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Investment Analysis and Lockheed Tri Star
1. Rainbow Products is considerin
g the purchase of a paint-mixin
g 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%.
[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.
[B] For a $500 per year additional expenditure, Rainbow can get a “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 cas
h flows of $4,500 per year in perpetuity. Should
Rainbow Products purchase the machine with the service contract?
[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 $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?
HINT: The formula for the present value (V) of an initial end-of-year perpetuity payout of $C
(growing at g%) per period, with a discount rate of k%, is:
V
C
kg
=
–
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291-031 Investment Analysis and Lockheed Tri Star
2
2. 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 ha
ve developed four different pro
posals 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 pro
posals involve abandoning
the existing stand. The
third proposal is to build a new stan
d. The fourth propo
sal is to rent a larger
stand in the ball park.
This option would involve $1,000
in up-front investment for ne
w 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 in
vestment. The
incremental cash flows associated with each of the proposals are:
Incremental Cash Flows
Project Investment Year 1 Year 2 Year 3
Add a New Window -$75,000 44,000 44,000 44,000
Update Existing Equipment -50,000 23,000 23,000 23,000
Build a New Stand -125,000 70,000 70,000 70,000
Rent a Larger Stand -1,000 12,000 13,000 14,000
•
Using the internal rate of return rule (IRR), which proposal(s) do you recommend?
•
Using the net present value rule (NPV), which proposal(s) do you recommend?
•
How do you explain any differences between the IRR and NPV rankings? Which rule is
better?
3. MBATech, Inc., is negotiating with the mayor of Bean City to start a manufacturing plant in an
abandoned building. The cash flows for MBAT’s proposed plant are:
Year 0 Year 1 Year 2 Year 3 Year 4
– 1,000,000 371,739 371,739 371,739 371,739
The city has agreed to subsidize MBAT.
The form and timing
of the subsidy have not been
determined, and depend on which investment criterion is used by MBAT. In preliminary discussions,
MBAT suggested four alternatives:
[A] Subsidize the project to bring its IRR to 25%.
[B] Subsidize the project to provide a two-year payback.
[C] Subsidize the project to provide an NPV of $75,000 when cash flows are discounted at 20%.
[D] Subsidize the project to provide an accounting rate of return (ARR) of 40%. This is defined as:

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Investment Analysis and Lockheed Tri Star 291-031
3
ARR
Average Annual Cash Flow
Investment
of Years
Investment
=
–
÷
#
2
You have been hired by Bean City to recommend
a subsidy that minimizes
the costs to the
city. Subsidy payments need not
occur right away; they ma
y be scheduled in later years if
appropriate. Please indicate
how much of a subsidy you would recommend for each year under each
alternative
suggested by MBAT.
Which of the four subsidy plans would you recommend to
the city if the appropriate discount rate is
20%?
4. You are the CEO of Valu-Added
Industries, Inc. (VAI). Your fi
rm has 10,000 shares of common
stock outstanding, and the current price of the stock is $100 per share. There is no debt; thus, the
“market value” balance sheet of VAI looks like:
VAI
Market Value
Balance Sheet
Assets $1,000,000 Equity $1,000,000
You then discover an opportunity to invest in a new project that produces positive cash flows
with a present value of $210,000. Your total initial costs for investing and developing this project are
only $110,000. You will raise the necessary capital for
this investment by issuing new equity. All
potential purchasers of your common stock will be fully aware of the project’s value and cost, and are
willing to pay “fair value” for the new shares of VAI common.
•
What is the Net Present Value of this project?
•
How many shares of common stock must be issued (at what price) to raise the required
capital?
•
What is the effect of this new project on the va
lue of the stock of the existing shareholders,
if any?
Lockheed Tri Star and Capital Budgeting
1
In 1971, the American firm Lockh
eed found itself in Congressi
onal hearings seeking a $250-
million federal guarantee to secure bank credit required for the completion of the L-1011 Tri Star
program. The L-1011 Tri Star Airbus is a wide-bodied commercial jet aircraft with a capacity of up to
400 passengers, competing with the DC-10 trijet and the A-300B airbus.
Spokesmen for Lockheed claimed that the Tri Star program was economically sound and that
their problem was merely a liquidity crisis caused by some unrelated military contracts. Opposing
the guarantee, other parties argued that the Tri Star program had been economically unsound and
doomed to financial failure from the very beginning.
1
Facts and situations concerning the Lockheed Tri Star program are taken from U. E. Reinhardt, “Break-Even
Analysis for Lockheed’s Tri Star: An Application of Financial Theory,”
Journal of Finance
27 (1972), 821-838, and
from House and Senate testimony.

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