HBS Case: Investment Analysis and Lockheed Tri Star

1. [A] The Payback period for this machine would be 7 years. The Net Present Value of this
project would be -$945.68. The Internal Rate of Return for this project would be 11.49%. All
computations were done in Microsoft Excel:

Time Cash
Index Flow Payback    
0 -35000 -35000    
1 5000 -30000    
2 5000 -25000    
3 5000 -20000    
4 5000 -15000    
5 5000 10000    
6 5000 5000    
7 5000 0 Payback Period  
8 5000      
9 5000      
10 5000      
11 5000      
12 5000      
13 5000      
14 5000      
15 5000      
      ($945.68) NPV@12%
      11.49% IRR

Rainbow Products should not purchase the machine because it doesn’t make sense to
invest in this project whether you utilize the IRR method or the NPV method. According to the
NPV methodology, the project should be rejected because it has a negative net present value of
-$945.68. According to the IRR methodology, the project should be rejected because the IRR is
less than the weighted cost of capital.

[B] According to the NPV methodology, Rainbow Products should purchase this machine
with the service contract because the service contract will produce a yearly cash flow of $4,500
in perpetuity. This makes the Net Present Value of the project equal to $2,500. The
computations are as follows:

NPV = PV(project) – Investment

NPV = (CO1/k) – CO0
NPV = (4500/.12) – 35000
NPV = 37500 – 35000
NPV = 2500

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 [C] According to the NPV methodology, Rainbow Products should invest in this project
because the 20% reinvestment and 4% growth rate will produce a positive Net Present Value of
$15,000. The computations are as follows:

NPV = PV(project) – Investment

NPV = (CO1/k-g) – CO0
NPV = (4000/(.12-.04)) – 35000
NPV = 50000 – 35000
NPV = 15000

2. Computations done in Microsoft Excel:

Note: A fifth option was included because adding a new window and updating existing
equipment were 2 projects that were not mutually exclusive.

Project Investment Year 1 Year 2 Year 3 IRR NPV@15%

$44,000.0 $44,000.0 $44,000.0
(1)Add New Window -$75,000.00 0 0 0 34.62% $25,461.91
(2)Update Existing $23,000.0 $23,000.0 $23,000.0
Equipment -$50,000.00 0 0 0 18.01% $2,514.18
(5)Add New Window & - $67,000.0 $67,000.0 $67,000.0
Update Equipment $125,000.00 0 0 0 28.10% $27,976.08
- $70,000.0 $70,000.0 $70,000.0
(3)Build New Stand $125,000.00 0 0 0 31.21% $34,825.76
$12,000.0 $13,000.0 $14,000.0
(4)Rent a Larger Stand -$1,000.00 0 0 0 1207.61% $28,469.88

Using the Internal Rate of Return rule, I would recommend renting a larger stand
because it yields the highest internal rate of return. Though IRR methodology suggests that any
projects that have an internal rate of return higher than the discount rate is a worthy project to
accept, it would also suggest that the project with the project with the highest IRR should be
taken. According to IRR, the rankings for these projects would (4), (1), (3), (5), and (2).

Using the Net Present Value rule, I would recommend building a new stand. This project
would produce the highest positive net present value. The net present value for this option
would be $34,825.76, which is greater than the NPV’s of all the other projects. According to the
NPV rule, any of the projects would be worthwhile; however the rankings of these projects
would be as follows: (3), (4), (5), (1), and (2).

The differences in rankings are due to the differences in prioritization of cash flows. The
NPV rule prioritizes the project that produces the most positive net cash flow, however the IRR
rule prioritizes the project that produces the highest return relative to an initial investment. The
IRR rule suggests that the owner should just rent a larger stand for his business because you
would get the most bang for your buck. In the event that there were capital constraints, then
the IRR rule may be a good tool for this, however the case did not indicate any type of capital
constraints, therefore applying a NPV rule would be better because it allows for the business
owner to understand which project would produce the most cash flows even after everyone is
paid off.

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4. The Net Present Value of this project is $100,000. Computations are as followed:
NPV = PV(project) – Investment
NPV = 210000 – 110000
NPV = 100000

VAI should issue 1,000 shares at $110 per share. If VAI issues new shares and utilizes the
capital raised for this project, then the costs of the project will fall on the new shareholders. The
total claim on assets that all VAI shareholders will have will be $1,210,000. This amount consists
of the $1,000,000 current market value of assets and $210,000 in the present value of expected
cash flows from the project. The total claim that each share has on assets will be $110
(1,210,000/11,000). This means that the existing shareholders will realize a gain of $10 on their
stock prices.

1,000 shares @ $110 per share = $110,000 required capital

$1,000,000 + $210,000 = $1,210,000 in assets claimed by shareholders

$1,210,000 / 11,000 shares outstanding = $110 value per share

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 Lockheed Tri Star and Capital Budgeting

At the planned (210 units) production levels, the true value of the Tri Star program was -$584.05
million. Computations done in Microsoft Excel:

Time Investmen Production Revenue Net Cash

End of Year "Index" t Costs s Flow
1967 0 ($100.00)     ($100.00)
1968 1 ($200.00)     ($200.00)
1969 2 ($200.00)     ($200.00)
1970 3 ($200.00)   $140.00 ($60.00)
1971 4 ($200.00) ($490.00) $140.00 ($550.00)
1972 5   ($490.00) $560.00 $70.00
1973 6   ($490.00) $560.00 $70.00
1974 7   ($490.00) $560.00 $70.00
1975 8   ($490.00) $560.00 $70.00
1976 9   ($490.00) $420.00 ($70.00)
1977 10     $420.00 $420.00
($584.05) NPV @ 10%
Accounting
($480.00) Profit
Units Per Year 35
Cost Per Unit 14
Revenue Per Unit 16
Total Number Sales 210

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 At a “break-even” production of roughly 300 units, Lockheed did not really break even in value
terms. The true value of the project at that production level was -$274.38 million. Computations were
done in Microsoft Excel:

Time Investmen Production Revenue Net Cash

End of Year "Index" t Costs s Flow
1967 0 ($100.00)     ($100.00)
1968 1 ($200.00)     ($200.00)
1969 2 ($200.00)     ($200.00)
1970 3 ($200.00)   $200.00 $0.00
1971 4 ($200.00) ($625.00) $200.00 ($625.00)
1972 5   ($625.00) $800.00 $175.00
1973 6   ($625.00) $800.00 $175.00
1974 7   ($625.00) $800.00 $175.00
1975 8   ($625.00) $800.00 $175.00
1976 9   ($625.00) $600.00 ($25.00)
1977 10     $600.00 $600.00
($274.38) NPV @ 10%
Accounting
$150.00 Profit
Units Per Year 50
Cost Per Unit 12.5
Revenue Per Unit 16
Total Number
Sales 300

The sales volume that the Tri Star program would need would be roughly around 388 units.
Given certain circumstances in the case, I assumed that there would an incremental cost savings of

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$7,500 per additional unit produced because of the “learning curve.” At a production level of 300 units,
the average cost per unit was $12.5 million per unit. In the case, analysts suggested that if Lockheed
could produce and sell 500 units, the average cost would have been about $11 million per aircraft. At a
total production level of roughly 388 units, the Tri Star program would reach true economic break-even.
The average cost per unit would be approximately $11.84 million. This would produce a positive NPV
using a opportunity cost of capital of 10%.

Time Investmen Production Net Cash

End of Year "Index" t Costs Revenues Flow
1967 0 ($100.00)     ($100.00)
1968 1 ($200.00)     ($200.00)
1969 2 ($200.00)     ($200.00)
1970 3 ($200.00)   $258.67 $58.67
1971 4 ($200.00) ($765.65) $258.67 ($706.99)
1972 5   ($765.65) $1,034.67 $269.01
1973 6   ($765.65) $1,034.67 $269.01
1974 7   ($765.65) $1,034.67 $269.01
1975 8   ($765.65) $1,034.67 $269.01
1976 9   ($765.65) $776.00 $10.35
1977 10     $776.00 $776.00
$0.09 NPV @ 10%
Accounting
$714.08 Profit
64.6666666
Units Per Year 7
Cost Per Unit 11.84
Revenue Per Unit 16
Total Number
Sales 388
Learning Curve
Cost Savings per
Additional Unit 0.0075
Additional Units 88

The investment decision made by Lockheed to pursue the Tri Star program was not a reasonable
one. A true value analysis shows that at the production level of 210 units, the project would result in an
economic loss of $584.05 million and an accounting loss of $480 million. In addition to miscalculating the
break-even level of production, Lockheed management overestimated the growth rate of air travel
industry. Because of this poor decision, Lockheed shares dropped from $70 per share to $3.25 a share.
Lockheed shareholders ultimately lost a total of $754.28 million in wealth.