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FINANCIAL DECISION

MAKING
LOCKHEED TRI STAR CASE STUDY
BY- ARWA KHERIWALA
Introduction
Highly regarded by the military, Lockheed sought to move into the
lucrative civilian commercial aviation sector and compete with Boeing,
McDonnell Douglas and Airbus. Lockheed began design and testing in 1966
on their entry, the Tri Star, which boasted a range of over 6,000 miles
with nearly 400 passengers and speeds of close to 600 mph. They had
already invested nearly $900 million in development costs. Carried by state
of the art Rolls Royce turbofan engines, the L-1011 was by all accounts, a
technological winner and might be the companys ticket back to solvency.
Problem
The summer of 1971 found the once formidable company on the brink of
disaster. Despite the nearly $1 billion in sunk costs, Lockheed was in
need of $250 million more to bring the plane to market, but its bankers
would not commit without federal loan guarantees. Spokespersons for
Lockheed claimed before Congress that the Tri-Star program was
economically sound and that their problem was mere liquidity crisis.
However, opposition to the guarantee focused on estimated break-even
sales the number of jets that would need to be sold for total revenue to
cover all accumulated costs.
The decision to invest in the Tri-Star project by forecasting the cash flow
associated with the project for a volume of 210 planes.
A valid estimate of the NPV of the Tri-Star project at a volume of 210
planes as of 1967 was -$584 M. This was clearly an unacceptable NPV.
Analysis and Solution

A break-even analysis revealed that the project reached economic


break-even with the production of 210 planes at $12.5 M per unit but
did not reach value break-even at that level of production. Also to
reach the value break-even Tri-Star would have to produce about 400
planes at $11.5 M per unit. The NPV at this rate was $117.13 M.

Tri-Stars recommended strategy should be of having a product mix of


both commercial and military markets to achieve positive accounting
and economic outcomes.
APPENDICES & REFERENCE LIST

High Flight by George A. Haloulakos


Appendix in Excel Sheet- Lockheed Case Study
Google Links
www.slideshare.com
www.coursehero.com
Pre-production costs estimated at $900 million incurred between 1967
and 1971.
Total of 210 planes delivered from 1972-1977
Revenues of $16 million per unit, 25% of revenue received 2 years in
advance of delivery.
Production costs of $14 million (at 210 units could decline to $12.5
million at 300) from 1971-1976.
Discount rate of 10% & 13% per year.
Lockheed TriStar Case Study Analysis
At Planned (210 Units) production levels ,what was the true value of
the Tri-Star program?
- r= 10% NPV= $-584.05 M r= 13% NPV= $-584.40 M

At a break-even production of roughly 300 units, did Lockheed really


breakeven in value terms?
- r=10% NPV= $-274.38 M r=10% NPV= $-329.96 M
Lockheed TriStar Case Study- Appendix 1
Production @ 210 Units
Lockheed Tri Star

Federal Grant 250

Avg Production Cost 14 M

Revenue per Aircraft 16 M

Guaranted Sales 210 35

Time Index t=0 t=1 t=2 t=3 t=4 t=5 t=6 t=7 t=8 t=9 t=10

Years 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977

Investment (100) (200) (200) (200) (200)

Cost 0 0 0 0 (490) (490) (490) (490) (490) (490)

Revenue 420 420 420 420 420 420

Pre-Revenue 140 140 140 140 140 140

Cash Flow (100) (200) (200) (60) (550) 70 70 70 70 (70) 420

NPV @ 10% ($584.05)

NPV @ 13% (584.40)


Lockheed TriStar Case Study- Appendix II
Production @ 300 Units
Lockheed Tri Star

Federal Grant 250


Avg Production Cost 12.5 M
Revenue per Aircraft 16 M
Guaranted Sales 300 50

Time Index t=0 t=1 t=2 t=3 t=4 t=5 t=6 t=7 t=8 t=9 t=10
Years 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977
Investment (100) (200) (200) (200) (200)
Cost 0 0 0 0 (625) (625) (625) (625) (625) (625)
Revenue 600 600 600 600 600 600
Pre-Revenue 200 200 200 200 200 200
Cash Flow (100) (200) (200) 0 (625) 175 175 175 175 (25) 600

NPV @ 10% ($274.38)


NPV @ 13% (329.26)
Lockheed TriStar Case Study Analysis

At what sales volume did the Tri-Star program reach the true economic ( as
opposed to accounting ) break-even?
-Tri-Star reached the true economic ( as opposed to accounting ) break-even at 400
Units.

Was the decision to pursue the Tri-Star program a reasonable one?


-No, it was not reasonable since NPV was negative at 10% as well as 13%.

What were the effects of this project on the shareholders?


-The common stock prices went down from $70 per share in 1967 to $ 3.25 in
1974.
Lockheed TriStar Case Study- Appendix III
Production @ 400 Units Break-Even Point
Lockheed Tri Star

Federal Grant 250


Avg Production Cost 11.5
Revenue per Aircraft 16 M
Guaranted Sales 400.00 66.67 1066.67 266.67 800.00

Time Index t=0 t=1 t=2 t=3 t=4 t=5 t=6 t=7 t=8 t=9 t=10
Years 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977
Investment (100) (200) (200) (200) (200)
Cost 0 0 0 0 (767) (767) (767) (767) (767) (767)
Revenue 840 840 840 840 840 840
Pre-Revenue 280 280 280 280 280 280
Cash Flow (100) (200) (200) 80 (687) 353 353 353 353 73 840

NPV @ 10% $263.94


NPV @ 13% 117.13
Lockheed TriStar Case Study

It is clear that the decision by Lockheed to embark on the Tri Star


program was not a reasonable one. Lockheeds share price
plummeted from $64 (Jan 1967) to $3.24 (Jan 1974).

The decision to pursue the Tri Star program was unreasonable and
overly ambitious. If the proper analysis was completed, this project
may have been terminated and the company could have invested its
capital in a profitable investment that would have increased
shareholder wealth.
Lockheed TriStar Case Study- Appendix IV
Production @ 500 Units
Lockheed Tri Star

Federal Grant 250

Avg Production Cost 11

Revenue per Aircraft 16 M

Guaranted Sales 500.0 83.3 1332.8 999.6

Time Index t=0 t=1 t=2 t=3 t=4 t=5 t=6 t=7 t=8 t=9 t=10

Years 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977

Investment (100) (200) (200) (200) (200)

Cost 0 0 0 0 (917) (917) (917) (917) (917) (917)

Revenue 1000 1000 1000 1000 1000 1000

Pre-Revenue 333 333 333 333 333 333

Cash Flow (100) (200) (200) 133 (783) 417 417 417 417 83 1000

NPV @ 10% $441.02

NPV @ 13% 260.80


Lockheed TriStar Case Study Evaluation
Accounting breakeven approximately 275 planes
$16M - $12.5M = $3.5M per plane
$3.5M275 = $962.5M profit versus $960M in actual development costs
known in 1970
This more realistic breakeven level announced subsequent to the
guarantees being granted.
NPV breakeven approximately 400 planes
Total free world market demand for wide-body aircraft approximately 323
planes
Optimistic estimate: total demand 775 and 40% of that is 310
Lockheed share price
$64 Jan 1967 drops to $3.25 Jan 1974
($64-$3.25)(11.3 Million shares)=-$599 Million
Compare to -$584 Million NPV
Lockheed TriStar Case Study Evaluation
Appendix-V
Cost Per unit
Source Production Units ( $ in Millions) NPV ( 13%)
Lockheed 210 14 M (584.40)
Industry analyst 300 12.5 M (329.26)
Actual Break-Even 400 11.5 M 117.13
Lucrative Project Scenario 500 11 M 260.80

Despite industry analysts prediction that 300 units as Lockheeds break-even sales point, at this
level, net present value remained insufficient to cover costs at negative $ 329.26 million. At 275
planes costing $3.5 million each, the company achieved accounting breakeven at $962.5 million
profit vs. $960 million in development costs. If the company had performed a true value break-
even analysis, management would have realized that roughly 400 Tri Star aircraft (about 67 per
year for six years) costing somewhere between $11.5 million and $12 million per unit would have
to be sold in order to break even.
The decision to pursue the Tri Star program was unreasonable and overly ambitious. If the proper
analysis was completed, this project may have been terminated and the company could have
invested its capital in a profitable investment that would have increased shareholder wealth.
Instead, the decision resulted in Lockheeds share price plummeting from $64 (Jan 1967) to $3.24
(Jan 1974).
The Lockheed Tri Star was an unfortunate case of a loss so big, it made history. Their initial
estimates to break-even proved to be extremely optimistic. Based on the cost data presented, it
is apparent the shareholders were poorly served, as investors evidently more properly valued the
project in the free market.
Given flawed decision-making, Lockheed lost $2.5 billion on the TriStar project and the
experience buried them in commercial aerospace.
Recommendation
Solution Reasons for having Product-Mix

Stock price performance reflects the firms


record in either adding or subtracting
Tri-Stars recommended strategy should be having intrinsic value based on execution of capital
a product mix of both commercial and military projects
markets to achieve positive accounting and Capital project yielding a positive NPV adds
economic outcomes. to a stock price while a negative NPV
reduces a stock price
Tri-Star can yields a positive NPV by adding a
product mix with positive value like the
Hercules C130 which have lower growth but
higher share of profits.
The stock price equation quantifying the
benefit for finding a way to retain and
convert Tri-Star into a financial winner:

Target Price = Low + NPV per share


Thank You