Tri Star 640 Case

Tri Star 640 Case

Dr. Gupta

University of Massachusetts Isenberg School of Management

GROUP 6

·   Maurice Bucknor

·   Abdoulaye Camara

·   Cynthia Martin

·   Stavros Memtsoudis

·   Sundeep Shukla

Executive Summary

In the mid 1960’s The Lockheed Corporation decided to join the competitive but growing market of commercial aircraft manufacturing. Lockheed enthusiastically introduced its plans for a wide-body aircraft, the TriStar, to rival products developed by Boeing and McDonnell Douglas.  The TriStar had a range of approx. 6340 miles and a speed of between 600-700mph (1).  However, the 400-passenger state-of-the-art plane project was initially challenged with production delays and then with staggering preproduction expenses of about $900 million dollars.

After having based their planning on very optimistic assumptions including capturing 35-40% of the wide-body aircraft market, Lockheed found itself in need of additional funds, forcing it to seek government guarantees in order to appease lenders. In 1971, the company faced congressional hearings during which it became obvious that Lockheed had significantly miscalculated its strategy.  In this case study analysis we retraced Lockheed’s assumptions in 1967 and calculated NPV given available cash flow information and the company’s plan to sell 210 units. This showed very clearly that even under these optimistic conditions, NPV was $ -585.1, thus suggesting that this project was not in the best interest of shareholders.

Before Congress, Lockheed presented a revised accounting analysis of the break-even point, which was based on the assumption that 275 planes would be sold (at a production cost of $12.5 million dollars and a sale price of $ 16 million dollars per unit). Under these circumstances the company claimed that it could generate $962.5 million dollars in profit. However, we found that even at 300 units of production, NPV for the project was still negative at $-274.38 million dollars, thus suggesting non-profitability.  In addition, there was a tremendous amount of sunk costs and additional needed capital that complicated the issue. 

We determined that the true-break-even-point required the production of 400 units at a production cost of $11.75 million dollars and a sale price of $16 million dollars, as evident by the positive NPV of $46.31million.This miscalculation by Lockheed almost caused the company to go bankrupt and eroded shareholder value by almost 95% or $776 million dollars between 1967 and 1974.

In summary, Lockheed embarked on the ambitious TriStar project with flawed analyses and unrealistic market expectations. Even when the company had to face the consequences of its decisions and petition Congress for guarantees, it failed to complete a proper and realistic analysis of cash flows and ignore sunk costs/opportunity cost. This in turn was the reason for the almost catastrophic erosion in shareholder value.  In addition, the Tri Star case shows the relevance of NPV, capital budgeting and forecasting in making business decisions. 

Introduction/Motivation

The 1960’s are widely viewed as the dawn of commercial aviation and the start of the jet age (2). With the projected increase in demand for the wide body aircraft, affiliated industries rushed to enter the market.  In this context, Lockheed Corporation, the largest defense contractor in the US, in existence since 1912, joined the likes of Boeing and McDonnell-Douglas as a competitor in this arena (3). Although it had not produced a commercial aircraft for almost 10 years, the company planned to introduce the TriStar.  The TriStar was a 400 passenger, wide-body aircraft, with a range of approx. 6000 nautical miles, and powered by Rolls-Royce engines.

From the beginning a number of problems became obvious, including those affecting engine and power plant development, setting the project back for a number of years (4). This and other difficulties led to the accumulation of approximately $1 billion dollars in development expenses.  With production beginning between 1968 and 1971 and having accumulated significant expenses, Lockheed faced an uphill battle.  They also faced tough competition with others questioning the demand for the aircraft, ultimately leading Lockheed to the brink of bankruptcy.  This situation required Lockheed to seek government-backed order guarantees in 1971 in order to secure additional bank loans (5).

At that time, a congressional hearing and independent investigations exposed serious budgetary miscalculations putting the profitability of the project into question.  Beyond the question “if the project ever had the chance of being profitable,” and “if not under what circumstances it could be”, came the ethical dilemma regarding the role of government in bailing out companies.  Thus, due to Lockheed’s own miscalculations they brought additional hardships on themselves and significant failure. This was especially problematic as Lockheed had been the long-term preferred defense contractor for the government and had established itself as an industry leader in many arenas (6).

In more recent times we have had bailouts of companies, schools, and organizations, which have been approved by legislators and been paid by taxpayers. Unfortunately, accustomed checks and balances are set aside in the name of pragmatism.  In the Lockheed case too, many were concerned that up to 60,000 jobs could be lost if the Tri Star project did not continue.   While the discussion regarding the ethics of government bailouts is an important one, in this analysis we sought to focus and analyze available data to determine: 1) if the TriStar project had a chance of profitability given original predictions regarding demand, cash flows and interest rates?  2) If profitability could be achieved given the revised data of increased demand and lower cost of production as suggested around the time of congressional hearings?  3) If the profitability could not be achieved under previous assumption, under what conditions the TriStar project could increase value to shareholders? 4) What impact the events between 1968 and 1971 had on shareholders?

Data/Analysis

The following paragraphs detail our approach to the four aspects of our analysis.

1) At planned (210) production levels, what was the true value of the Tri Star Program?

Lockheed’s estimates were that they could break even after producing and selling between 195 and 205 units. In 1971, at the time of the Congressional hearings, Lockheed had orders for 103 units as well as options-to-buy for another 75 (i.e. in best case scenario sales of 178 units), but expecting to sell many more. However, no net present value calculation including preproduction expenses had been performed.

The following information provided in the case presentation was used to calculate net present value for this project:

NPV calculation and data used can be found in the Results section Table 1). We used the provided excel spreadsheet to compute the calculations. Calculations are based on the assumptions that 210 planes would be sold over 6 years (35 units/year). Cost of production per plane was $14 million dollars with a sale price of $16 million dollars. The assumed discount rate applied was 10%. As evident in the table, preproduction costs of $900 million dollars were accumulated. The production for these planes was planned between 1971 and 1977.   In addition, the production cost was calculated to be at $490 million dollars per year (35U*$14 million dollars). Revenue was expected to be $ 560 million dollars per year (35U*$16Million), however deposits of $4 million dollars/plane (=$140 million dollars) were received in year 1970 and 1970 and taken into account.

2) At a “break even” production of roughly 300 units, did Lockheed really break even in value terms?

Lockheed claimed before Congress hearings that with a revised sales number of 275 units, the company could break even, while industry analysts suggested this number had to be about 300 airplanes.  In order to test for this scenario (i.e. 300 units sold at 50 planes per year), we took into account potential savings in production due to the “learning curve effect,” resulting in a cost to produce of $12.5 million dollars/unit. With sale prices and discount rates remaining the same as in the original scenario, Table 2 details the cash flows.

3) At what sales volume did the Tri Star program reach true economic (as opposed to accounting) break even?

Lockheed’s development costs in 1972 were estimated at $960 million dollars. Lockheed’s accounting analysis of the break-even point was based on the assumption that at a volume of 275 planes at a production cost of $12.5 million dollars and a sales price of 16 million dollars per unit, the company could generate $3.5 million dollars x 275units= $962.5 million dollars in profit to break even.

Interestingly, using the accounting approach with the original plan of 210 planes at a profit of $2 million dollars for each unit, profits would have come to $420 million dollars, significantly less than half of the $960 million dollars spent in preproduction.  Furthermore, a true value break-even analysis was not performed.

In order to perform such an analysis, we estimated the cost of production at various volumes, taking into account the “learning curve effect”.  This suggested that while the cost was 14 million dollars per plane at a volume of 210 units and $12.5 million dollars at 300 units, a further decrease in the number sold could lead to a cost of $11 million dollars for 500 units (Table A).

Table A)

	Units	Cost/Unit
Primary assumption	210	14
Revised assumption	300	12.5
High volume assumption	500	11

Taking this information and applying the “learning curve effect”, we constructed a table linking production volumes proportionately to production costs (Table B).

Table B)

Units	Cost/Unit
300	12.5
350	12.125
400	11.75
450	11.375
500	11

We then performed NPV calculations at every increment of 50 Units at the corresponding production costs (i.e 350, 400, 450) until a positive NPV was achieved.

It appears that approximately 400 units needed to be produced for the NPV to become positive.

However, given the optimistic overall demand of 775 aircraft in the following decade and a targeted market share of 35% to 40% (equating to 270 to 310 Lockheed aircraft), expecting to sell 400 planes does not seem feasible.

4) Was the decision to pursue the Tri Star program a reasonable one? What were the effects of this project on Lockheed shareholders.

The results of the above analyses and the market information at the time was used to answer this question. Lockheed’s assumptions were that the wide-body industry would be growing at a 10% rate and Lockheed could capture 35 to 40% of the market.

To evaluate impact on shareholders we took into account the fall in share price from a high of $71 in 1967 to $3.25 in 1974.  The number of outstanding shares and a market cap of $11.3 million dollars were used to calculate the value loss incurred by shareholders.

Results:

1) Given the resulting cash flows and assumptions, the NPV at 210 units is -584.05. Thus, at the planned production levels the project was not profitable.

See cash flows and calculations in Table 1.

2) Even at the revised production levels of 300 units, the NPV was -274.38, thus leading us to conclude that this project even under the revised assumptions was unprofitable (Table 2).

3) The tables below represent cash flows and resulting NPV analysis at various levels of production. Production of approximately 400 Units at a cost of $11.75 million dollars and sale price of $16 million dollars at a discount rate of 10%, yields a positive NPV, thus representing the approximate volume at which the project would seem profitable.

4) The decision to pursue this program was based on optimistic assumptions and failure to perform realistic and accurate calculations of net present value taking into account the extensive preproduction costs.  The assumption that the industry would be growing at a 10% rate while in actuality it was closer to 5% and the idea that Lockheed could capture 35 to 40% of the market was very ambitious.  This miscalculation led to a huge erosion in shareholder value as evident by the decrease in share price from a high of $71 in 1967 to $3.25 in 1974.  This represents an over 95 % drop. Given the number of outstanding shares of market cap of $11.3 million dollars, shareholders lost approximately $776 million dollars. From Jan 1967 to Jan 1971, share prices dropped from $64 to $11, which corresponds to a loss of approx $ 600 million dollars. Therefore, in both scenarios the drop in share value is bigger than NPV of -584 million.

Conclusion:

This analysis underlines the conclusion that Lockheed’s TriStar project was not in the shareholders interest. Calculations of profitability were not computed appropriately, and the market for this aircraft was misjudged. Sunk costs were ignored and targets not met; which exemplified poor strategy.

It is not surprising that Lockheed sold only 250 planes in total until the end of this project in 1981.

References:

1) Aircraft Wiki.  Lockheed L-1011 Tri Star.  Accessed 27 March 2017.  http://aircraft.wikia.com/wiki/Lockheed_L-1011_Tristar

2) http://www.century-of-flight.net/Aviation%20history/airliners/2nd%20upload/timeline%2060s1.htm

Accessed 28 March 2017.

3) Wikipedia Contributors.  “Lockheed L-1011 Tri Star”.  Wikimedia Foundation.  21 March 2017 Web.  Accessed 10 March 2017. 

4)"Lockheed's Rough Ride with Rolls-Royce." Time.   15 February 1971 Web.  Accessed 10 March 2017. 

5) https://cdnc.ucr.edu/cgi-bin/cdnc?a=d&d=DS19710506.2.8 Accessed 28 March 2017.

6) Wikipedia Contributors.  ”Top 100 Contractors of the U. S. Federal Government.”  Wikimedia Foundation.  25 February 2017.  Accessed 10 March 2017.

 

Rainbow Products

PART A:

Year	0	1	2	3	4	5	6	7	8	9	10	11	12	13	14	15
Cash Flow	-35000	5000	5000	5000	5000	5000	5000	5000	5000	5000	5000	5000	5000	5000	5000	5000

CALCULATE NPV: -945.68

CALCULATE IRR: 11.49%

CALCULATE PAYBACK: 7 YEARS

NPV: INITIAL INVESTMENT+ PV OF ANNUITY

PV (.12, 15, -5000) -35000= -945.68

NPV IS NEGATIVE SO THIS PROJECT SHOULD BE REJECTED AND THEY SHOULD NOT BUY THE PAINT MIXING MACHINE

IRR: PROFIT/INVESTMENT

-35000 + 5000/ (1+IRR)^15

=11.49%

PAYBACK:

INITIAL COST/COST SAVINGS PER YEAR OR CASH FLOW

35000/5000= 7 YEARS

PART B:

Year	0	1	2	3	4	5	6	7	8	9	10	11	12	13	14	15
Cash Flow	-35000	4500	4500	4500	4500	4500	4500	4500	4500	4500	4500	4500	4500	4500	4500	4500

CALCULATE NPV: 2500

CALCULATE IRR: 12.86%

CALCULATE PAYBACK: 7.78 YEARS

NPV: INITIAL INVESTMENT+ PV OF ANNUITY

PV= C/K-G

-35000 +PV (.12, 1000, -4500)

4500/.12= $37,500

$37500- $35000

= $2500

SINCE NPV IS POSITIVE, RAINBOW SHOULD ACCEPT AND PURCAHSE WITH A SERVICE CONTRACT

IRR: PROFIT/INVESTMENT

IRR VALUES: 12.86%

PAYBACK:

INITIAL COST/COST SAVINGS PER YEAR OR CASH FLOW

$35000/4500= 7.78 YEARS

PART C

Year	0	1	2	3	4	5	6	7	8	9	10	11	12	13	14	15
Cash Flow	-35000	4000	4160	4326.4	4499.456	4679.4342	4866.6116	5061.2761	5263.7271	5474.2762	5693.2473	5920.9771	6157.8162	6404.1289	6660.2940	6926.70579

CALCULATE NPV: 15000

CALCULATE IRR: 15.43%

CALCULATE PAYBACK: 7.61 YEARS

NPV: INITIAL INVESTMENT+ PV OF ANNUITY

PV= C/K-G

-35000 + 50000

$15000

IRR: PROFIT/INVESTMENT

IRR VALUES: 15.43%

PAYBACK:

$35000/4600

7.61 YEARS

RAINBOW SHOULD PICK OPTION C AS IT HAS THE HIGHEST NPV OUT OF ANY OF THE QUESTIONS.  THUS, IT SHOULD ACCEPT THE OPTION TO ENHANCE THE CAPABILITY OF THE MACHINE OVER TIME. 

Concession Stand

	Investments	Year 1	Year 2	Year 3	Discount Rate	NPV	IRR
Projects
Add New Window	-75000	44000	44000	44000	0.15	$25,461.91	34.6%
Update Existing Equipment	-50000	23000	23000	23000	0.15	$2,514.18	18.0%
Build a New Stand	-125000	70000	70000	70000	0.15	$34,825.76	31.2%
Rent a Larger Stand	-1000	12000	13000	14000	0.15	$28,469.88	1207.6%

Best NPV

Best IRR

Based on the internal rate of return rule (IRR), the best proposal option is renting a larger stand. IRR of 1207.6%.

Based on the net present value (NPV) rule, the best proposal option will be to build a new stand. NPV at $34,825.76.

When evaluating a project, it is generally assumed that the higher the value of these two parameters, the more profitable the investment is going to be. Both the instruments are made use of to indicate whether it is a good idea to invest in a particular project or series of projects over a period of time which is normally more than a year.

The obvious difference is that IRR does not onsider the discount rate while the NPV does.

Among other differences is that IRR tells the company whether making investments on a project will generate the expected profits or not, while NPV tells the value of any project today and the estimated value of the same project after a few years taking into account inflation and some other factors. If this value is positive, the project can be undertaken, but if it is negative, it is better to discard the project.

MBA Tech

MBA Tech, Inc is negotiating with the mayor of Bean City to start a manufacturing plant in an abandoned building.  The city has agreed to subsidize MBAT with the following parameters.

a.     Subsidize the project to bring its IRR to 25%:

IRR formula used to obtain 18%.  Trial and error was used to back into the number needed for subsidy to obtain an IRR of 25%.  Total subsidy needed:  1,000,000-877,880=$122,120 if the subsidy was given in the first year.  If the subsidy was given annually, total subsidy would be $106,389.  See part 2 of A. 

b.     Subsidize the project to provide a two year payback:

c.      Subsidize the project to provide an NPV of $75000 when cash flows are discounted at 20%.

d.     Subsidize the project to provide an accounting rate of return of 40%. 

                                               i.     ARR=  average annual cash flow-investment no. of years/ investment /2

Which of the four subsidy plans would you recommend to the city if the appropriate discount rate is 20%?

A.	Year 0	year 1	year 2	year 3	year 4				subsidy	NPV .20
	-1000000	371739	371739	371739	371739		18%			($31,388.67)
	-877,880	371739	371739	371739	371739		25.00%		122120	$70,378.00
		371739	371739	371739	371739
Subsidy	0	335543.32	335543.32	335543.32	335543.32		1342173.28
net cash flow	-1000000	707282.32	707282.32	707282.32	707282.32		25%
B.
	Year 0	year 1	year 2	year 3	year 4
B.	-1000000	371739	371739	371739	371739				256,522	$877,717.08
subsidy	$0.00	128261	128261
net cash flow	($1,000,000.00)	$500,000.00	$500,000.00	$371,739.00	$371,739.00
cumulative cash flow	($1,000,000.00)	($500,000.00)	$0.00
C.
	Year 0	year 1	year 2	year 3	year 4
	-1000000	371739	371739	371739	371739
	0	1	1	1	1
	-1000000	371740	371740	371740	371740	($37,663.81)			($37,663.81)
	Year 0	year 1	year 2	year 3	year 4
	-1000000	371739	371739	371739	371739
	0	43521.80477	43521.80477	43521.80477	43521.80477
	-1000000	415260.8048	415260.8048	415260.8048	415260.8048	$75,000.00			112,666
D.  ARR	Year 0	year 1	year 2	year 3	year 4
	-1000000	371739	371739	371739	371739
	0	1	1	1	1
	-1000000	371740	371740	371740	371740	0.24348
	Year 0	year 1	year 2	year 3	year 4
	-1000000	371739	371739	371739	371739
	0	78261	78261	78261	78261
	-1000000	450000	450000	450000	450000	0.4			173,913
		Subsidy	year 0	year 1	year 2	year 3	year 4	NPV	IRR
		0	-1000000	371739	371739	371739	371739	($37,666.40)	18%
		122120	-877880	371739	371739	371739	371739	$84,453.60	25%
		256522	-743478	371739	371739	371739	371739	$218,855.60	35%
		112,666	-887334	371739	371739	371739	371739	$74,999.60	24%
		173,913	-826087	371739	371739	371739	371739	$136,246.60	28%

Option C, with NPV of $75,000 with a discount rate of 20%, requires the lowest subsidy from the city and would be the preferred choice.

Value Added Industries

1)   What is the net value of the project?

a.     To calculate the NPV we use the formula NPV = present value of future cash flows - required investment.

                                               i.     Which would get us to the following:  $210,000 - $110,000 = $100,000

2)   How many shares of common stock must be issued (at what price) to raise the required capital.

a.     We would need to raise a total of $110,000 by selling 1,100 shares at the common stock price at $100 per share

3)   What is the effect of this new project on the value of the stock of the existing shareholders, if any?

a.     There will always be a short-term negative effect from any stock with any move for internal or external investments which needs outside financing. It is a necessity in a company to remove themselves from stagnation and investments is one of the best ways. In the short term, the stock will become “diluted” from the increase shares however, when they shareholders start to see the results of their investments the amount of money (also EPS) they hold within the company will increase greatly.