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 project’s return.
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. 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.
In breaking out the data as referenced in the Harvard Business case study from the Lockheed Tri-Star situation, organizing the cash flows in a spreadsheet depiction offered the most clarity in analyzing the information.
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 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.
The management’s 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.
The investment decision made by Lockheed to proceed with the Tri Star project was not very well thought through. Even though break even...