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3-218-04 Financial Management

Professor Iwan Meier


Applying Net Present Value
1. Case: Lockheed TriStar
2. Bond valuation, yield to maturity
3. Forward rates, synthetic bonds

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Lockheed TriStar Case

• HBS Case 9-291-031 (case packet)


• Net present value and break-even analysis.

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History
• Lockheed has been known for their extensive line of military
products. In 1966, Lockheed started working on what would
become their first commercial jetliner: the L-1011 TriStar.
• The TriStar was considered the world’s most
technologically-advanced airlner at the time of the
introduction.
• In 1966, more than four years before the venerable Boeing
747 inaugurated service, many airlines were already
showing interest in a smaller, medium-range widebody
jetliner.
• While Lockheed came to settle with the L-1011, McDonnell
Douglas were also finalizing their designs on what would
become the DC-10. The third competitor for a wide-bodied
commercial jet aircraft with a capacity of up to 400
passengers was the A-300B airbus.
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History
• By the beginning of 1968, both Lockheed and McDonnell
Douglas had their designs refined, in anticipation of large
orders from major U.S. airlines.
• In an effort to attract orders, Lockheed agreed to sell under
favorable terms if Eastern Airlines and Trans World Airlines
(TWA) selected the L-1011.
• Finally, on the evening of March 28, TWA came to an
agreement with Lockheed, and it was only few hours later
when Eastern followed suit. On the morning of March 29,
letters of intent for a total of 144 commitments valued at
$2.16 billion were signed and the L-1011 program officially
came to a launch.
• Within a month of the launch date, the L-1011 had attracted
a total of 176 commitments (firm orders plus options-to-buy)
worth 2.74 billion.
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Case Questions

• At planned (210 units) production levels, what was


the true value of the Tri Star program?
• At a “break-even” production of roughly 300 units,
did Lockheed really break even in value terms?
• At what sales volume did the Tri Star progarm
reach true economic (as opposed to accounting)
break-even?
• Was the decision to pursue the Tri Star program a
reasonable one? What were the effects of this
“project” on Lockheed shareholders?

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Lockheed TriStar - Questions

• We first need to forecast the cash flows associated


with the Tri-Star project for the projected volume of
210 planes.

Then we can ask:


• What is a valid estimate of the NPV of the Tri-Star
project at a volume of 210 planes as of 1967?
• What is the “break-even” level of sales?

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Lockheed TriStar – Forecasts

• 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 cost of $14 million (at 210 units, could
decline to $12.5 million at 300) from 1971-1976.
• Discount rate of 10% per year.
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Lockheed TriStar – Costs and Revenues

• 210 planes (1972-1977)


– Planes per year = 210/6 = 35.
• Production costs (1971-1976)
– 35 × $14M = $490M per year (1 yr prior to
delivery).
– Pre-production costs of $900M.
• Revenues (1972-1977)
– Total revenues: 35 × $16M = $560M per year.
– Deposits: 0.25 ×$560M = $140M (2 yrs in
advance).
– Net revenues: $560 - $140 = $420M on delivery.

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Lockheed TriStar – Accounting Profits

• How do we calculate the accounting profits for this


endeavor?
• Take the per plane revenues, subtract the per
plane costs, and multiply this difference by the
number of planes for total production profits. Then
subtract preproduction cost estimates. Estimated
revenue $16 M per plane.
• Estimated cost $14 M per plane.
• At 210 planes this gives only $420 M production
profits?

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Lockheed TriStar – Accounting Break-Even

• Now remember that they expect a learning curve


effect on costs to kick in at about 300 planes and
lower per plane cost to about $12.5 M.
• Production profit per plane is then $3.5 M.
• This gives $700 M in production profits at 275
planes if they “expect” this per plane cost at 200
planes.
• At 275 planes times $3.5 gives $962.5 M. With the
actual preproduction costs of $960 M this is break-
even in profit terms, and we see a realistic
expectation reported by Lockheed.
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Lockheed TriStar – Conclusions

• Accounting break-even approximately 275 planes


– $16M - $12.5M = $3.5M per plane.
– $3.5M × 275 = $962M profit versus $960M in
development costs.

• NPV break-even approximately 400 planes.


– Total free world market demand for wide-body
aircraft approximately 325 planes.

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Lockheed Share Price

• $64 (Jan 1967) drops to $11 (Jan 1971).


• ($64 - $11) × (11.3 Million shares) = -$599M.
• Compare to -$584M NPV.
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Default-free Fixed Income Securities

• Debt issued by governments of developed


countries and some newly developed countries.
• A fixed income security promises to pay fixed
coupon amounts at pre-specified dates and a fixed
principal amount at the maturity date.
• When there is no promised coupon and a fixed
income security pays only a fixed principal amount
at maturity, the security is called a pure discount
bond or a zero coupon bond.
• Otherwise, it is a coupon bond.

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Treasury Securities

Examples of default-free fixed income securities:


• Treasury securities with maturity less than one year
are all discount bonds and are called Treasury Bills.
• Treasury securities with maturity between 1 year
and 10 years pay coupons and are called Treasury
Notes.
• Treasury securities with maturity greater than 10
years pay coupons and are called Treasury Bonds;
some treasury bonds are callable – the U.S.
Treasury has the right to buy these bonds from
investors at a fixed price after a certain pre-
specified date.
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Yield to Maturity on a Discount Bond

• We will denote the price of a discount bond with


payment F (face value) in j years by Bj
F
Bj =
(1 + y j ) j
• where yj is the yield to maturity of the discount
bond. It is the internal rate of return on the bond.
• Suppose that a 5-year discount bond with face
value of $100 is selling for $90.
• What is the yield to maturity on this bond?
1
100 ⎛ 100 ⎞ 5
= 90 and y = ⎜ ⎟ − 1 = 2.13%
(1 + y 5 )5 5
⎝ 90 ⎠
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How to Get Yields
In addition to T-bills, discount bonds in the form of U.S.
Treasury strips are traded. Prices of these strips are reported, for
example, in the Wall Street Journal. The convention is to report
these prices in price per 100 units of face value.

ci – stripped coupon interest Chg. – change


bp – Treasury bond, stripped principal compared to previous
np – Treasury note, stripped principal trading day in 32nds.

Colons in bid-and-asked Asked Yld. – Yield to


quotes represent 32nds: maturity using the ask
99:05 means 99 + 5/32. price.

Strips stands for Separate Trading of Registered Interest and Principal of Securities, as
well as the fact that the coupon payment is effectively "stripped“ from the bond principal.
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U.S. Treasury Strips Quotes

On May 15, 2000, a U.S. Treasury (coupon) strip with


maturity May 2005 has a bid price of 72:01 and an
ask price of 72:04 (numbers after the colon are in
32nds).
• At which price can we buy a 5-year strip?
• Notice that this gives us an expression for
B5 72 + 4 32
= = 0.72125
100 100
• The yield to maturity of this strip satisfies:
1
100 ⎛ 100 ⎞ 5
B5 = 72 + 4 32 = or y 5 = ⎜ ⎟ − 1 = 6.75%
(1 + y 5 )5 ⎝ 72 + 4 32 ⎠
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Discount Bond Prices

100

80
Ask Price

60
July 8, 2003
40
January 21, 2002
20

0
0 5 10 15 20 25 30
Maturity

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Convert Prices into Yields

Discount bond price


100
Bj =
(1 + y j ) j
and yield to maturity
1
⎛ 100 ⎞ j
y j = ⎜⎜ ⎟ −1

⎝ Bj ⎠
• This gives the yield curve or term structure of
interest rates, which shows the yield as a function
of time to maturity.
• Notice that the discount factors are embedded in
these formulas.
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Term Structure of Interest Rates

8.0%

January 21, 2002


6.0%
Yield to Maturity

4.0%

July 8, 2003
2.0%

0.0%
0 5 10 15 20 25 30
Maturity

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The Living Yield Curve

Source: www.smartmoney.com
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Forward Contract

• You have a customer who knows that she will have


a need for $200,000 for one year starting from the
end of the third year. She would like to get into a
forward contract with you to borrow this $200,000
three years from now for one year in the form of a
discount loan. You observe the following pattern of
discount bond prices:
j 1 2 3 4
Bj 95.24 89.00 82.78 76.29
yj 0.050 0.060 0.065 0.070
• Can you quote your customer an interest rate for
this forward loan?
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Forward Contract

• Buy 3-year discount bonds.


Number of bonds: 200,000/100 = 2,000.
Total cost is 2,000 × 82.78 = $165,560.
• Finance this by selling 4-year discount bonds.
Number of bonds: 165,560/76.29 = 2,170.14.
This creates a liability in year 4 of 2,170.14 × 100 =
217,014.
Year 0 1 2 3 4
Purchase of B3 -165,560 0 0 200,000
Sale of B4 165,560 0 0 0 -217,014
Total 0 0 0 200,000 -217,014

• The yield to maturity for the loan is


217,014/200,000 – 1 = 8.5%.
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One Period Forward Rate

• The forward rate between time j - 1 and time j is


given by
B
f j = j −1 − 1
Bj
• There is a link between strip prices, yields, and
forward rates:
100
Bj =
(1 + f1 )(1 + f2 )K(1 + f j )
and
y j = [(1 + f1 )(1 + f2 )K(1 + f j )] j − 1
1

• Given the yield curve, we can derive the (implied)


term structure of forward rates.
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Term Structure of Forward Rates

8.0%
January 21, 2002

6.0%
Yield to Maturity

4.0%

July 8, 2003
2.0%

0.0%
0 5 10 15 20 25 30
Maturity

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Forward Rates in General

• The implied m period forward rate, starting in j


periods is given by
1
⎡(1 + y j +m ) j +m ⎤ m
1 + f j ,m = ⎢ ⎥
⎣ (1 + y j ) ⎦
j

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Implied Forward Rate

• Suppose you observe the following yield to


maturities on Treasury strips:
Years to maturity 1 2 3 4 5
Yield to maturity 4.0% 4.7% 5.2% 5.6% 5.8%

• What is the implied 3-year forward rate starting in


two years?

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Valuing Cash Flows

• You are considering an investment in a project that


generates the following cash flows with perfect
certainty:
Date 1 2 3 4
Cash flow 50 100 100 50

• You also know the discount bond prices:


j 1 2 3 4
Bj 98.00 95.00 92.00 88.00
yj 0.0282
fj 0.0326

• What would you be willing to pay for this project?


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Valuing Cash Flows

• (i) Use discount bond prices:


98 95 92 88
PV = × 50 + × 100 + × 100 + × 50 = 280
100 100 100 100
• (ii) Use yields to maturity:
50 100 100 50
PV = + + + = 280
1.0204 1.0260 2 1.02823 1.0325 4
• (iii) Use forward rates:
50 100 100
PV = + +
1.0204 1.0204 × 1.0316 1.0204 × 1.0316 × 1.0326
50
+ = 280
1.0204 × 1.0316 × 1.0326 × 1.0455
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Price, Yield to Maturity, Forward Rate

Maturity Face Value Price PV Factor yj Forward Rate


j Bj (P/F, yj, j) Return from 0 from j-1 to j
to j fj
1 100 B1 B1/100 100/B1 - 1 f1 = y1
2 100 B2 B2/100 (100/B2)1/2 - 1 f2 = B1/B2 - 1
3 100 B3 B3/100 (100/B3)1/3 - 1 f3 = B2/B3 - 1
. . . . . .
. . . . . .
. . . . . .
n 100 Bn Bn/100 (100/Bn)1/n - 1 fn = Bn-1/Bn - 1

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Implied Yield Curve
• Suppose that there are no discount bonds trading
with exactly one and two years to maturity, but
there are coupon bonds with these maturities
trading.
• Data on coupon bonds with annual coupons:
Years to maturity 1 2
Face value 1,000 1,000
Coupon rate 5% 8%
Current price 997.5 1048.0

• How can we infer the yield curve?

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Implied Yield Curve

• Price of 1-year coupon bond:


B
997.5 = 1 × (50 + 1000 )
100
100
Therefore B1 = 997.5 × = 95.0 and y1 = 5.3%.
1050

• Price of 2-year coupon bond:


95 B
1048.0 = × 80 + 2 × (80 + 1000 )
100 100
100
Therefore B2 = 972.0 × = 90.0 and y2 = 5.4%.
1080

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Synthetic Discount Bond

• Given the coupon bonds from the previous


example, how could you synthetically construct 1
and 2-year discount bonds?

• Buy 100/1050 = 0.09523 1-year coupon bonds.


– This results in 100 in one year.
– The cost is 0.09523 × 997.5 = 95.

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Synthetic Discount Bond

• A 2-year coupon bond yields 1080 in two years.


Buy 100/1080 = 0.09259 units to give 100 in two
years.
– This results in coupons at year 1 of 0.09259 ×
80 = 7.407.
– To eliminate these, sell 7.407/1050 = 0.00705
units of the 1- year coupon bonds.
– The total cost is 0.09259 × 1048 – 0.00705 ×
997.5 = 90.
– This creates the same cash flow as a 2-year
discount bond.
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