Lockheed Finance case Study. I recommend that the investment decision made by Lockheed to embark on the Tri Star program was unreasonable

by ishahp (student)

University Degree Business and Administrative studies

Memo

Recommendation

I recommend that the investment decision made by Lockheed to embark on the Tri Star program was unreasonable. According to my analysis, the company could have terminated this project and invested its capital in a more profitable investment. Eventually, this poor decision resulted in dramatic loss of wealth for the Lockheed shareholders totaling a loss of $766 million in stock value.

Rationale for Decision

The Lockheed case illustrates the significance of NPV analysis in Capital Budgeting.

Using discount rate of 10% in the given the scenario and with the project volume of 210 aircrafts, I found the NPV to be -$584 million. This was definitely an unacceptable NPV. The revised break-even analysis by Lockheed revealed that the project reached economic break-even with the production of 275 aircrafts at $12.5 million per unit. But as per my analysis, the break-even at this level of the production was not attained. Despite industry analysts predicting 300 units as Lockheed’s break-even sales point, the net present value remained insufficient to cover costs at negative $274 million.

I found that Tri-Star will have to produce roughly 400 aircrafts costing between $11.75 million to $12 million per unit to reach the break-even value. The NPV at this rate was $42 million.

Given that the Tri Star project was riskier than the typical Lockheed operation, the appropriate discount rate should be higher than 10%. At an estimated 15% discount rate, break-even sales will be 500 aircrafts costing $11.75 million per unit. Under a worst case scenario at a 20% cost of capital, the firm should produce 636 aircrafts at the same per unit cost.

The below analysis ...

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I found that Tri-Star will have to produce roughly 400 aircrafts costing between $11.75 million to $12 million per unit to reach the break-even value. The NPV at this rate was $42 million.

The below analysis explains the fall in the share price by 95% from 1967 to 1973 and how the project destroyed the shareholder value.

Definition of Problem

Lockheed was in need of $250 million more to bring the plane to market, but its bankers would not commit without federal loan guarantees. Adding to their concern, were the cost over runs in other projects.

Also, Lockheed estimated a break-even sales point between 195 and 205 aircraft. At the point this estimate was given, only 103 firm orders were taken plus 75 options-to-buy (essentially 178 aircrafts in demand).

This shows that the company failed to perform basic net present value calculations that would have provided a realistic proposal of costs and cash flows which may have resulted in termination of the project.

Discussion and Analysis

The Lockheed Tri Star was an unfortunate case of such a huge loss. Their initial estimates to break-even proved to be extremely optimistic and it is clear that the shareholders were poorly served.

Given flawed decision-making, “Lockheed lost $2.5 billion on the TriStar project and the experience buried them in commercial aerospace. In December 1981, Lockheed announced they were stopping production and taking a final $400 million write off to cover the costs. They never made another major airliner.”

Lockheed anticipated a rapid growth in the airline industry that was not supported by the economic conditions during the 1970s.

Wrap-up / Reaffirm Recommendation:

The investment decision made by Lockheed to proceed with the Tri Star project was grossly erroneous. Even though break even production was calculated to be 210 units, a true value analysis shows that this number was much lower than the production actually needed to break even. In addition, the market conditions were grossly overestimated. Thus, this poor decision resulted in dramatic loss of wealth for the Lockheed shareholders totaling a loss of $765 million in stock value.