Philippine College

Foundation
City of Valencia
College of Business

Investment Analysis and Lockheed Tristar

(A Case Study Analysis)
Group 4
Group 4
Lanorias, Merlinda
Camarillo, Cindy
Cabañeros, Jane
Caroro, Sharon
Asedre, Jerry
RAINBOW PRODUCTS

Rainbow Products is considering the purchase of a

paint-mixing machine to reduce labor costs. The
savings are expected to result in additional cash
flows to Rainbow of $5,000 per year. The machine
costs $35,000 and is expected to last for 15 years.
Rainbow has determined that the cost of capital for
such an investment is 12%.
RAINBOW PRODUCTS
a. Compute the payback, net present value (NPV), and internal rate of return (IRR) for
this machine. Should Rainbow purchase it? Assume that all cash flows (except the
initial purchase) occur at the end of the year, and do not consider taxes?
Solution:
Payback (Period) = 35000/5000 = 7 years
With the current discount rate of 12%,
Considering the PV of the cash flows --
Payback period = 16.17 years, which implies that the purchase shall not be economical
at current discount rate
RAINBOW PRODUCTS

Net Present Value (NPV) = -35000+ Sum of PV of all 15 years.

NPV = $ -945.68
IRR = 11.49% (Pls refer working in attached excel sheet)
Rainbow Products should not purchase the paint mixing m/c as the investment is not
economical with (-)ve NPV and IRR less than discounted rate.
RAINBOW PRODUCTS
b. For a $500 per year additional expenditure, Rainbow can get “Good as New” service
contract that essentially keeps the machine in new condition forever. Net of the cost of
the service contract, the machine would then produce cash flows of $4500 per year in
perpetuity. Should Rainbow products purchase the machine with the service contract?

Cash Flow decreases to (5000-500) = 4500$ every year and continues as perpetuity
PV of perpetuity = 4500/0.12 = $37500
NPV = (37500 - 35000) = $2500
IRR =4500/35000 = 12.86%, which is more than the discount rate
Rainbow Products should purchase the paint mixing m/c with the above plan as the
investment is a favorable proposition with (+)ve NPV and IRR more than discounted rate.
RAINBOW PRODUCTS
c. Instead of the service contract, Rainbow engineers have devised a different option to
preserve and actually enhance the capability of the machine over time. BY reinvesting
20% of the annual cost savings back into new machine parts, the engineers can increase
the cost savings at a 4% annual rate. For example, at the end of year one, 20% of the
$5000 cost savings ($1000) is reinvested in the machine; the net cash flow is thus $4000.
Next year, the cash flow from cost savings grows by 4% to $5200 gross, or 4160 net, of
the 20% reinvestment. As long as the 20% reinvestment continues, the cash flows
continue to grow at 4% in perpetuity. What should Rainbow products do?
RAINBOW PRODUCTS

PV of growing perpetuity = 4000/(0.12-0.04) = $50000

NPV = -35000+50000 = $15000
Rainbow Products should purchase the paint mixing m/c with the above scenario as the investment
is a favorable proposition with (+)ve NPV
CONCESSION STAND AT BALL PARK
Suppose you own a concession stand that sells hot dogs, peanuts, popcorn, and beer at
a ball park. You have three years left on the contract with the ball park, and you do not
expect it to be renewed. Long lines limit sales and profits. You have developed four
different proposals to reduce the lines and increase profits.
The first proposal is to renovate by adding another window. The second is to update
the equipment at the existing windows. These two renovation projects are not
mutually exclusive; you could take both projects. The third and fourth proposals involve
abandoning the existing stand. The third proposal is to build a new stand. The fourth
proposal is to rent a larger stand in the ball park. This option would involve $1,000 in
up-front investment for new signs and equipment installation; the incremental cash
flows shown in later years are net of lease payments. You have decided that a 15%
discount rate is appropriate for this type of investment. The incremental cash flows
associated with each of the proposals are:
CONCESSION STAND AT BALL PARK
You have decided that a 15% discount rate is appropriate for this type of investment.
The incremental cash flows associated with each of the proposals are:
CONCESSION STAND AT BALL PARK
d. Using the internal rate of return rule (IRR), which proposal(s) do you recommend?
CONCESSION STAND AT BALL PARK
e. Using the net present value rule (NPV), which proposal(s) do you recommend?
CONCESSION STAND AT BALL PARK

f. Which rule should we use? Why?

NPV Rule shall be chosen.
We shall choose Project 03 on overall basis as NPV is more relevant
and justifiable tool when compared to IRR and the basic reasons are
as follows -
a) IRR rule is misleading due to difference in size of investment.
b) The difference in ranking is explained by the size of investment
c) NPV interprets the absolute return in terms of present value
indicating the size of the investment as well which is not reciprocated
in the IRR rule.
d) Using NPV rule, we recommend "Build a new stand".
Lockheed Tristar and Capital Budgeting

INTRODUCTION

FACTS OF THE CASE

PROBLEMS AND OBJECTIVES

AREAS OF CONSIDERATION

SOLUTION AND RECOMMENDATION

 INTRODUCTION

Capital investment decisions encompass long-term financial

strategies aimed at strategically allocating resources to projects
that enhance shareholder value. Various methodologies exist for
evaluating the viability of potential investments, with the most
effective approaches incorporating considerations such as the
net present value of anticipated cash flows, determined using an
appropriate discount rate commensurate with the project's risk
profile, alongside management's risk assessment. In the case of
Lockheed, which will be thoroughly examined subsequently,
management opted to proceed with the Tri Star project based on
a break-even analysis. However, as will be demonstrated, this
decision proved to be flawed, as it neglected to account for the
net present value of investments, resulting in substantial loss of
company value.
 FACTS OF THE CASE

1. In 1971, Lockheed sought a $250 million federal guarantee for

bank credit needed to complete the L-1011 Tri Star program, a
wide-bodied commercial jet competing with the DC-10 trijet and
the A-300B Airbus.
2. Lockheed claimed the Tri Star program was economically viable,
citing a liquidity crisis due to unrelated military contracts.
Opponents argued the program was financially unsound from
inception.
3. Debate focused on estimated break-even sales, with Lockheed's
CEO stating break-even would occur between 195 and 205 aircraft,
despite having only 103 firm orders and 75 options-to-buy.
Lockheed aimed to capture 35%-40% of the projected 775 wide-
body market over a decade.
4. Pre-production phases began in 1967, lasting four years with
estimated development costs ranging from $800 million to $1
billion. Cash outflows approximated $900 million.
 FACTS OF THE CASE

5. Production phase, planned from 1971 to 1977 with 210

aircraft output, estimated average unit production cost at $14
million per aircraft. Annual production costs of $490 million were
spread over six years.
6. Expected price per aircraft in 1968 was $16 million, with
annual revenues of $560 million over six years, offsetting
inflation-based cost increases.
7. Lockheed received deposits toward future deliveries, with a
quarter of the price received two years early.
8. Experts estimated Lockheed's cost of capital at 9%-10%. Due
to higher risk, a 10% discount rate was applied to Tri Star cash
flows.
9. Lockheed revised break-even sales to 275 units in 1972, after
securing loan guarantees. Industry analysts estimated 300 units
for break-even.
PROBLEMS AND OBJECTIVES

1. At originally planned production levels (210 units), what

would have been the estimated value of the Tri Star program as
of the end of 1967?

2. At "break-even" production of roughly 300 units, did Lockheed

break even in terms of net present value?

3. At what sales volume would the Tri Star program have reached
true economic (as opposed to accounting) break-even?

4. Was the decision to pursue the Tri Star program a reasonable

one? What effects would you predict the adoption of the Tri Star
program would have on shareholder value?
AREAS OF CONSIDERATION

In evaluating the Lockheed Tri Star case, several key areas of consideration
emerge. Firstly, understanding market demand is paramount, requiring an
analysis of current and projected trends for wide-bodied commercial jets.
Economic conditions, air travel patterns, and competitor offerings all play
crucial roles in this assessment. Financial viability stands as another critical
factor, necessitating a comprehensive evaluation of the Tri Star program's
development costs, production expenses, revenue projections, and potential
returns on investment. Additionally, a thorough examination of the
competitive landscape within the aerospace industry is essential, including an
assessment of rival manufacturers' strengths and weaknesses and their
impact on market dynamics. Technological advancements, regulatory
compliance, and risk management also demand attention, as they
significantly influence the program's success and sustainability. Moreover,
exploring strategic partnerships, leveraging government support, nurturing
customer relationships, and ensuring long-term viability are integral
components of a holistic approach to decision-making in this complex
scenario.
 SWOT Analysis
Strengths
• Innovative product offering in the wide-
bodied commercial jet market.
• Established brand reputation and expertise
within the aerospace industry.
• Secured government support with a $250
million federal guarantee.
0 •
• Potential to capture a significant market
share (35%-40%).
1 Lockheed operations.
Threats
• Intense competition from rival aircraft
manufacturers.
• Economic uncertainty affecting airline
profitability and demand.
• Regulatory challenges and changes
impacting costs and timelines.
• Technological advancements posing risks of
product obsolescence.
Weaknesses
0
• Exceeded initial development cost estimates.
2 • Limited firm orders and options-to-buy,
indicating uncertain market demand.
• Extended pre-production phases and delays
impacting cash flow.
Higher financial risk compared to typical
SWOT
0 Opportunities
3 •
•
Projected market growth in air travel.
Potential cost reductions through learning
curve effects.
• Opportunities for ongoing technological
0 advancements.
• Potential for strategic partnerships to
4 enhance market reach.

Environmental
Focus on sustainability affecting
aircraft design and regulatory
compliance.
Climate change concerns leading
to stricter emissions standards and
regulations.
Legal
Adherence to safety standards and
intellectual property laws
influencing product development.
Impact of government policies and
trade agreements on market
dynamics and regulations.
Technological
Continuous innovation shaping aircraft
design and manufacturing processes.
Technological trends like digitalization
impacting customer interactions and
operational efficiency..
PESTLE Analysis
Political
Government support with a $250
P million federal guarantee.
Impact of regulatory changes on
safety standards and production
costs.
E E
Economic
PESTLE
Influence of economic conditions
on air travel demand and aircraft
sales.
L S Economic downturns affecting
airline profitability and investment
in new aircraft.
T Sociological
Technological advancements driving
innovation and product competitiveness.
Growing environmental concerns
influencing customer preferences and
industry practices.
 SOLUTION TO THE PROBLEM
At originally planned production levels (210 units), what would have been the
Problem 1 estimated value of the Tri Star program as of the end of 1967?

IRR = - 9.09%
 SOLUTION TO THE PROBLEM

Problem 2 At "break-even" production of roughly 300 units, did Lockheed

break even in terms of net present value?

IRR = 2.38%
 SOLUTION TO THE PROBLEM
At what sales volume would the Tri Star program have reached
Problem 3
true economic (as opposed to accounting) break-even?

Accounting breakeven is achieved when 300 units are produced at $12.5 million cost/u
Accounting breakeven is not exactly right as we do not know the continuous effect of
learning curve on the production cost of the aircraft
 SOLUTION TO THE PROBLEM
At what sales volume would the Tri Star program have reached
Problem 3
true economic (as opposed to accounting) break-even?

• At 10% rate of discounting, breakeven is achieved using NPV method at 480 units of production at $12.5 per unit production cost
• At 15% rate of discounting, breakeven is achieved using NPV method at 500 units of production at $11 per unit production cost
(400 units gives a loss of $146.43)
• At 20% rate of discounting, breakeven is achieved using NPV method at 507 units of production at $11 per unit production cost
 SOLUTION TO THE PROBLEM
How did decision to pursue Tri star program affect shareholder
Problem 4
value?
Based on the data provided, the Tri Star program emerges as a
significant failure, indicated by the negative absolute returns even when
factoring in the sale of 300 units of commercial aircraft. This downturn
resulted in a sharp decline in share prices, quantifiable through the
following calculation:

At the close of 1967, the share price per unit stood at $70,
while in January 1974, it plummeted to $3.

Throughout this period, the outstanding shares amounted to

approximately 11.39 million units. Consequently, the total decline in
shareholders' value can be computed as (70 - 3) * 11.3 = $797.3 million
(approximate).
In conclusion, the Lockheed Tri Star case underscores the
challenges inherent in aerospace capital investments, with
cost overruns, limited demand, and risky project to a
significant decline in shareholder value. Moving forward,
thorough market research, rigorous financial analysis, and
effective risk management are crucial for informed
decision-making. Additionally, proactive measures such as
strategic partnerships, innovation, and market
responsiveness are essential for enhancing competitiveness
and mitigating risks in the aerospace industry. Learning
from this case, companies can navigate challenges more
effectively and position themselves for long-term success.
Thank you