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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
projects 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

1
2

Investopedia.com
Textbook

In breaking out the data as referenced in the Harvard Business case study 3 from
the Lockheed Tri-Star situation, organizing the cash flows in a spreadsheet
depiction offered the most clarity in analyzing the information.
Analysis at 210 aircraft production

End of year
1967
1968
1969
1970
1971
1972
1973
1974
1975
1976
1977

Cash flow ($mm)

up front costs

Time "index"
0
1
2
3
4
5
6
7
8
9
10

unit prod costs

-100
-200
-200
-200
-200

deposit

-490
-490
-490
-490
-490
-490

revenue remainder

140
140
140
140
140
140

420
420
420
420
420
420
Rev-costs
NPV @ 10%
IRR

net flow
-100
-200
-200
-60
-550
70
70
70
70
-70
420
-480
($530.95)
-9%

Analysis at 300 aircraft production

End of year
1967
1968
1969
1970
1971
1972
1973
1974
1975
1976
1977

Cash flow ($mm)

up front costs

Time "index"
0
1
2
3
4
5
6
7
8
9
10

unit prod costs

-100
-200
-200
-200
-200

-900

deposit

-625
-625
-625
-625
-625
-625
-3750

revenue remainder

200
200
200
200
200
200

600
600
600
600
600
600
3600

1200
Reveues-costs
NPV @ 10%
IRR

net flow
-100
-200
-200
0
-625
175
175
175
175
-25
600
150
($249.44)
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
3

The Harvard Business case Lockheed Tri Star and Capital Budgeting facts and situations
were taken from U.E. Reinhardt, Break-Even Analysis for Lockheeds Tri Star: An Application
of Financial Theory, Journal of Finance 27 (1972, 821-838, and from House and Senate
Testimony.

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

End of Year
1967
1968
1969
1970
1971
1972
1973
1974
1975
1976
1977

Cash Flow ($mm)

Time "Index" up front costs
unitprod costs
deposit
revenue remainder
net flow
0
(100)
(100)
1
(200)
(200)
2
(200)
(200)
3
(200)
252
52
4
(200)
(740)
252
(688)
5
(740)
252
756
268
6
(740)
252
756
268
7
(740)
252
756
268
8
(740)
252
756
268
9
(740)
756
16
10
756
756
Production Cost perunit
Sales Volume

11.75
378

Revenue - Costs
NPV@10%

707
(0.28)

The managements 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 ProductsCase 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 StandCase 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
ns

Investm
ent

Year
Year
Year
Project
1
2
3
IRR
NPV
44,00
44,00
44,00
25,46
1
Add a New Window
-75,000
34.6%
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
12,00
13,00
14,00 1207.6 28,47
5
Rent a Larger Stand
-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 NPVs, 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 projects value and cost, and
are willing to pay fair value for the new shares of VAI common.

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