Investment Analysis &

Lockheed Case Study

1A-Compute the payback, NPV and IRR for the Machine.

Should Rainbow purchase it?

The payback is 35,000/5,000= 7 years

Computation of the NPV :
NPV= -35,000 + 5,000 / ( 1 + 12%)^ 15
NPV = $- 947. 67
Computation of the IRR :
0= -35,000 + 5,000 / ( 1 + IRR)^ 15
IRR= 11.49%
The NPV of this project is negative and the IRR is lower then the Cost of Capital (12%)
Rainbow products shouldnt go for it.

1B-For $ 500 additional rainbow can get good as new service contract for
the machine. The machine would then produce a cash flow of $ 4500 for
perpetuity. Should he buy the machine?

Based on the perpetuity formula we can compute the PV in this case :

Computation of the PV :
PV= Cash flow per year/ cost of capital)
=4,500 / 0.12
= $37,500
Computation of the NPV :
NPV= -Initial investment + PV
= -35,000 + 37,500
NPV=$2,500
Rainbow products could buy this machine with the service contract if they intent to use it
in the long-run.

1C
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 $5,000 cost
savings ($1,000) is reinvested in the machine; the net cash
flow is thus $4,000. Next year, the cash flow from cost
savings grows by 4% to $5,200 gross, or $4,160 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?

1c
Computation of the PV :

PV= C/ k-g
In this case C (end of year perpetuity payout) = 5,000-1,000= $4,000
k= 12%, discount rate
g= 4%, growing rate at perpetuity
PV= 4,000 / (0.12-0.04) = $50,000
Computation of the NPV :
NPV= -35,000+ 50,000 = $15,000
The rainbow products company should invest in this project because its NPV is largely
positive because of the reinvestment of 20% of the annual cost, even though this is in a very
long term vision.

2
Discount Rate
Year
0
1
2
3
IRR

NPV

15%

1
-75000
44000
44000
44000
35%

PROPOSAL
2
3
-50000 -125000
23000
70000
23000
70000
23000
70000
18%

31%

4
-1000
12000
13000
14000
1208%

25,461.9
34,825.7 28,469.8
1 2,514.18
6
8

2A
2a-Using

the internal rate of return rule (IRR), which

proposal(s) do you recommend?

All projects are acceptable because all the IRRs are

higher than the discount rate(15%)
Looking at the internal rate o return of each project,
rent a larger stand is the best at it is the project with
the highest IRR.

2B
Using the net present value rule (NPV), which proposal(s)

do you recommend?
All the projects are acceptable because all the NPVs

are positive Looking at the net present value of each

project, build a new stand Is the project with the
highest NPV

2C-How do you explain any differences between the IRR and NPV
rankings? Which rule is better?

NPV and IRR is used in capital budgeting by the companies to know

which new investment or expansion opportunity is better.

In the net present value method, the present value is determined by
discounting the future cash flows of a project at a predetermined or
specified rate called the cut off rate based on cost of capital.
But under the internal rate of return method, the cash flows are
discounted at a suitable rate by hit and trial method which equates the
present value so calculated to the amount of the investment.
The proposal choice should be based on the NPV rule since the NPV
gives an absolute amount of increase in amount whereas IRR gives only
a relative measures.
Even though the IRR of the project number 4 is largely superior to the
one of the first project, the rule is to go for the project with the highest
NPV.

Cash flows w/o

subsidy

CF 0
1000000

CF1

CF 2

CF 3

CF 4

371739 371739 371739371739

A) In order to find the subsides for this project we first have to find the amount of yearly cash
flow with the initial investment of $1,000,000 who will present an IRR of 25%
NPV=

Subsidize- NPV = CF0 + ^CF/ (1+25%)^4

CF=
CF=

1,000,000/2.3603
423675

Subsidize- 423675-371739

51935.95657

B) In order to have a two-year payback period with an initial investment of

1,000,000 we need two annual cash flow of 500000
Subsidize
5,00,000-371739
128261

C) To compute the annual cash flows for this project

we need to solve:
NPV=

75000

CF=

1075000/2.58

CF=

4,15,87
7

Subsidize-

44,138

D) This project present an ARR of 40% and an initial investment of $ 1000000, we use the formula of the ARR to
compute the annual cash flow of this project:
ARR=

0.4

ARR= (Average annual cash flow - Investment/4)/ (investment)/2

0.4=((1000000/4))/ (1000000/2)
CF=
Subsidize-

4,50,000
78,261

 In order to determine which of the four plans would be best to subsidy, we computed the PV

of the subsidies cash flow at the discount rate of 20%, and assumed that the one with lower
subsidy is the best for the city.

First Plan,
PV=

51935.95/(1+20%)^4
1,34,448.38

Second Plan,
PV=

128261/(1+20%)^2
1,95,954.30

Third Plan,
PV=

44170/(1+20%)^4
11,448.38

Fourth Plan,
PV=to the city 78261/(1+20%)^4
We will recommend
the subsidies with the lowest present
value, the one of plan number 3.
2,02,596.95

4A-What is the Net Present Value of this project?

PV of Cash Flow-210000
Initial investment-110000
NPV=-initial investment+ PV of cash Flow

=(110000)+210000
=100000

4B-How many shares of common stock must be issued (at what price) to
raise the required capital?

4B- Assuming issue N shares when price is P.

N*P=110,000(1)P=1,210,000/(10,000+N) (2)
Then computing the result
So N=1000 P=$110

4C-What is the effect of this new project on the value

of the stock of the existing shareholders, if any?
4C-Stock price rises up $10 Stock holder make the
profit

CASE STUDY
QUESTIONS

5A-At planned (210 units) production levels, what was the

true value of the Tri Star program?

In order to compute the NPV in t=0 of the Tri Star

program for 210 units you have to discount every

years total Cash Flow with a rate of 10% and
compute the sum:
NPV (210 units) = $ - 584 Million
Calculated in excel

5B-At a break-even production of 300 units did Lockheed really

break even in value terms?

At first, we need to discount fixed costs of production which are the

preproduction costs of the project.

NPV = 100 + 200/1.1 + 200/1.21 + 200/1.3 + 200/1.46 = 733.97
When the production level is 300, each plane produced contributes
3.5 million to Lockheed.
This can be calculated as 16-12.5 = 3.5
16 is the sales price of one plane
12.5 is the production cost,
yielding a contribution margin of 3.5 million dollars.
Thus, the break-even point can be found from the following equation:
Fixed costs / contribution margin = 733.97 / 3.5 = 209.706 ~ 210
planes

However the production was only 210 planes which

is below 300 so the cost was 14m$ and the

contribution margin was 2 m$
The correct break-even point would be 733.97 / 2 =
366.98~ 367 planes
Therefore, Lockheed did not break even in value
terms at a break-even production of 300 units.

 We can verify this by comparing the net present values at the end of 1967 of both cash

outflows and cash inflows.

Revenues (received normally):
NPV = 600/1.61 + 600/1.77 + 600/1.94 + 600/2.14 + 600/2.35 + 600/3.59 = 1784.82
Revenues (received two years early)
NPV = 200/1.3 + 200/1.46 + 200/1.61 + 200/1.77 + 200/1.94 + 200/2.14 = 719.88
Production costs
NPV = 625/1.46 + 625/1.61 + 625/1.77 + 625/1.94 + 625/2.14 + 625/1.2.35 = 2045.10
Preproduction costs
We already know from above that the net present value of preproduction costs is 733.97
NPV = discounted revenues -discounted costs

NPV = 1784.82 + 719.87 - 2045.10 - 733.973

NPV = - 274.38
We can see that the net present value of the project is negative when the level of
production is 300.
This proves that Lockheed did not break even in value terms when the production level
was 300.

5C-At what sales volume did the Tri Star program reach true
economic break-even?

5C-At what sales volume did the Tri Star program reach true
economic break-even?
When the level of production is 210, each plane

contributes 2 million to Lockheed. Therefore, we can

find the break-even point with the following
equation:
Fixed costs / contribution margin = 733.97 / 2 =
366.99~ 367 planes

Was the decision to pursue the Tri Star program a reasonable

one? What were the effects of these projects on Lockheed's
shareholders?
The decision to Pursue the Tri star program was not

reasonable because the Net Operating Profit for 210

units represents $ -480 Million.
For the shareholders the value of the share fell from

$70 to $3 during this period.

Thank You!!