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Lockheed Tri Star and Capital Budgeting—Case Analysis
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...