Lockheed Tri Star and Capital Budgeting

Case Analysis
as Presented to:
Professor Raj Gupta

Prepared & Presented By:

Christopher Naso
Richard Goshgarian
Elizabeth Torres
Brian Cherry
Michael Lee

October19, 2010

SCH-MGMT 640: Financial Analysis and Decisions

University of Massachusetts Amherst Isenberg School of
Business
Executive Summary

Professor Gupta, many organizations use financial methods to determine the

viability of projects and decisions based in the initial required investment. The
financial industry has many standards regarding these methods, with the most
commonly used being Internal Rate of Return (IRR) and Net Present Value (NPV).
Each method encompasses positives and negatives; however if either are used
without fully understanding what their prospective results reveal, mistakes can
be made and under-estimations of return will happen. In a recent case Lockheed
Martin chose to use the Internal Rate of Return to value their Tri Star project. We
have determined this to be a mistake and, through this case analysis, will show
where the mistake happened. We also intend to explain how using the Net
Present Value method will uncover a different, more realistic picture of the
project’s return.

Introduction/Motivation

Capital investment decisions are long term finance decisions designed to

strategically invest in projects that will improve the value of the corporation for
stockholders. There are several methods for determining which projects are
worth investing in, but the best methods must take into account the net present
value of the future cash flows resulting from the investment using an
appropriate discount rate for the project and managements assessment of the
risk involved.12 In the Lockheed case, which we will examine in detail below, the
management made a decision to proceed with the Tri Star project based on a
break-even analysis. As we will show, their analysis was flawed, failing to take
into account the net present value of their investments resulting in a huge loss
of value for the company.

Data/Analysis Section

In breaking out the data as referenced in the Harvard Business case study3 from
the Lockheed Tri-Star situation, organizing the cash flows in a spreadsheet
depiction offered the most clarity in analyzing the information.

1
Investopedia.com
2
Textbook
3
The Harvard Business case “Lockheed Tri Star and Capital Budgeting” facts and situations
were taken from U.E. Reinhardt, “Break-Even Analysis for Lockheed’s Tri Star: An Application
of Financial Theory, “ Journal of Finance 27 (1972, 821-838, and from House and Senate
Testimony.
Analysis at 210 aircraft production

Cash flow ($mm)

End of year Time "index" up front costs unit prod costs deposit revenue remainder net flow
1967 0 -100 -100
1968 1 -200 -200
1969 2 -200 -200
1970 3 -200 140 -60
1971 4 -200 -490 140 -550
1972 5 -490 140 420 70
1973 6 -490 140 420 70
1974 7 -490 140 420 70
1975 8 -490 140 420 70
1976 9 -490 420 -70
1977 10 420 420
Rev-costs -480
NPV @ 10% ($530.95)
IRR -9%
Analysis at 300 aircraft production

Cash flow ($mm)

End of year Time "index" up front costs unit prod costs deposit revenue remainder net flow
1967 0 -100 -100
1968 1 -200 -200
1969 2 -200 -200
1970 3 -200 200 0
1971 4 -200 -625 200 -625
1972 5 -625 200 600 175
1973 6 -625 200 600 175
1974 7 -625 200 600 175
1975 8 -625 200 600 175
1976 9 -625 600 -25
1977 10 600 600
-900 -3750 1200 3600
Reveues-costs 150
NPV @ 10% ($249.44)
IRR 2%

As seen above, @ 210 aircraft produced over the above time perior, the
$900mm in up front costs are spread over the first 5 years (1967-1971), annual
unit production costs of $490mm are spread over 6 years (1971-1976), and
revenues are divided up in both 25% deposits ($140mm/yr from 1970-1975) and
the balance of those revenues ($420mm/yr from 1972-1977).

In analyzing the cash flows @ 210 aircraft for those 10 years keeping in mind the
10% assumed cost of capital to Lockheed, the NPV of the project was -
$530,950,000; the IRR of the project was -9%, and the project lost $480,000,000
when netting the costs of the project with the revenues.

In the scenario where production is assumed @ 300 aircraft for that time period,
the $900mm in upfront costs remains over the first 6 years, however unit
production costs rise a bit to $625mm/year ($12.5mm/aircraft at 50
aircraft/year) as do revenues assuming all built aircraft are sold at that same
$16mm price/aircraft and in a similar deposit and balance paid scenario.

In analyzing the cash flows @ 300 aircraft for those 10 years assuming the same
10% cost of capital, the NPV of the project improved but remains negative at -
$249,440,000, the IRR remains sub par at 2%, but the accounting break even
analysis actually shows a small profit of $150,000,000.

Analysis of Breakeven Sales Volume

Cash Flow ($mm)

End of Year Time "Index" up front costs unit prod costs deposit revenue remainder net flow
1967 0 (100) (100)
1968 1 (200) (200)
1969 2 (200) (200)
1970 3 (200) 252 52
1971 4 (200) (740) 252 (688)
1972 5 (740) 252 756 268
1973 6 (740) 252 756 268
1974 7 (740) 252 756 268
1975 8 (740) 252 756 268
1976 9 (740) 756 16
1977 10 756 756

Production Cost perunit 11.75

Sales Volume 378

Revenue - Costs 707

NPV @10% (0.28)

The management’s breakeven analysis determined that 210 units would need to
be sold to start making money on the Tri Star project. However, if the Net
Present Value of the project is used in this analysis as shown above, it is clear
that an excess of 378 units would need to be sold in order to make the net
present value of the project come out positive. At this level of production, it was
assumed that the per unit cost of production would be further reduced to $11.75
million.
Conclusion

The investment decision made by Lockheed to proceed with the Tri Star project
was not very well thought through. Even though break even production was
calculated to be 210 units, a true value analysis shows that this number was
much lower than the production actually needed to break even. In addition, the
market conditions were grossly overestimated. They anticipated a rapid growth
in the airline industry that was unsupported by the economic conditions during
the 1970s. Ultimately this poor decision resulted in dramatic loss of wealth for
the Lockheed shareholders totaling a loss of $757 million in stock value.

APPENDIX

I. Rainbow Products—Case Analysis

Rainbow Products is considering the purchase of a paint-mixing machine to

reduce labor costs. In addition to simply analyzing the purchase of the machine
alone, Rainbow also has the option to purchase a service contract along with the
machine or, instead, choose to reinvest some of the productivity savings from
the equipment back into the machinery in lieu of service. Here is the analysis of
all three scenarios.

What we know:

Annual CF=$5,000

Initial cost=$35,000

N=15 years

i=12%

A. Payback, NPV, and IRR of paint-mixing machine.

i. Payback of the machinery is 7 years ($35,000/$5,000)

ii. NPV of the machinery is $-945.67 (CFO=-35,000; CF1-CF15=

5,000; IRR=12)

iii. IRR of the machinery is 11.49

Conclusion: Based on both the NPV and the IRR of the machine,
Rainbow should reject this purchase.

B. NPV of paint mixing machine including a service contract

 i. NPV = $2,000 = -35,500 +37,500

Conclusion: Based on the NPV, Rainbow should purchase the

machine with the service contract.

C. NPV of paint mixing machine and reinvestment of savings in lieu of service

contract.

i. NPV=$15,000 = -35,000 + 50,000

Conclusion: Based on NPV, Rainbow should reinvest 20% of the cost

savings into its machine annually.

II. Concession Stand—Case Analysis

For part 2, you own a concession stand that sells hot dogs, popcorn, peanuts and
beer at a ball park. There are only three years left on your contract. The current
stands architecture has restricted sales and profits due the inability to efficiently
service long lines. Four proposals to deal with this issue were devised and are
listed below. Using the incremental cash flows for years 1-3 and a discount rate of
15%, you must recommend what proposal to take. A recommendation should be
based off an analysis using the IRR rule only and then with the NPV rule. Any
differences between the rankings should be explained.

Optio Investm Year Year Year

ns Project ent 1 2 3 IRR NPV
Add a New 44,00 44,00 44,00 25,46
1 -75,000 34.6%
Window 0 0 0 2
Update Existing 23,00 23,00 23,00
2 -50,000 18.0% 2,514
Equipment 0 0 0
Add new window & 67,00 67,00 67,00 27,97
3 -125,000 28.1%
update equipment 0 0 0 6
70,00 70,00 70,00 34,82
4 Build a New Stand -125,000 31.2%
0 0 0 6
Rent a Larger 12,00 13,00 14,00 1207.6 28,47
5 -1,000
As shown the table, an additional proposal is listed, which is a combination of
options one and two. Options one and two are the only two projects that were not
mutually exclusive, which is why a fifth option was created. In addition, the IRR and
NPV for the respective options were calculated and included in the table.

Using the Internal rate of return (IRR)

Using the internal rate of return rule, renting the larger stand is what we would
recommend. This proposal yielded the highest IRR. The remainder of the
proposals had positive IRR's as well. This suggests that the opportunity costs of
capital are less than the internal rate of return, making any of them a worthy
project to accept.

Using the Net Present Value (NPV)

Based off the Net Present Value (NPV) rule, we would recommend option 4, which is
to build a new stand. The NPV for this option is 34,826, which is greater than any of
the other options, including options one and two combined. Since the other options
also have positive NPV’s, they could very well be worthwhile projects but ranked
lower than option 4.

Differences Between IRR and NPV, which is better

For this case, the IRR and NPV rules suggest different rankings. The IRR method
suggested that renting the larger stand should have the highest priority whereas
the NPV method suggested that building a new stand did. The reason for this
relates to the timing of cash flows. The total cash inflow for building a new stand is
greater than the option to rent a larger stand but because it occurs later, the IRR
suggests that renting the larger stand is better.

When the discount rate is lower than approximately 18.2, the NPV for building a
new stand is higher. When the discount rate is greater than approximately 18.2%,
the NPV of renting a larger stand is higher. Since the discount rate is 15%, building
a new both was prioritized higher. This is demonstrated in the plot below. The NPV
method is better because it prioritized the option that generated the most cash flow
as the highest. In the event that there were capital constraints, the IRR method
may be more appropriate but that information was not presented in this case.
IV. Valu-Added Industries, Inc (VAI) Fiancial information as a result of
investment in a Project.

For part IV You are the CEO of Valu-Added Industries, Inc. (VAI). Your firm has 10,000 shares of
common stock outstanding, and the current price of the stock is $100 per share. You then
discover an opportunity to invest in a new project that produces positive cash flows with a
present value of $210,000. Your total initial costs for investing and developing this project are
only $110,000. You will raise the necessary capital for this investment by issuing new equity. All
potential purchasers of your common stock will be fully aware of the project’s value and cost, and
are willing to pay “fair value” for the new shares of VAI common.