4. You are the CEO of Valu-Added Industries, Inc. (VAI). Your firm 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 $1,000,000 Equity Assets $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 value of the stock of the existing shareholders, if any? Lockheed Tri Star and Capital Budgeting In 1971, the American firm Lockheed found itself in Congressional 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 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. 291-031 Investment Analysis and Lockheed Tri Star The debate over the viability of the program centered on estimated "break-even sales" the number of jets that would need to be sold for total revenue to cover all accumulated costs. Lockheed's CEO, in his July 1971 testimony before Congress, asserted that this break-even point would be reached at sales somewhere between 195 and 205 aircraft. At this point, Lockheed had secured only 103 firm orders plus 75 options-to-buy, but they testified that sales would eventually exceed the break-even point and that the project would thus become "a commercially viable endeavor." Costs The preproduction phases of the Tri Star project began at the end of 1967 and lasted four years, after running about six months behind schedule. Various estimates of the up-front costs ranged between $800 million and $1 billion. A reasonable approximation of these cash outflows would be $900 million, occurring as follows: End of Year Time "Index" Cash Flow ($mm) 1967 -$100 1968 -$200 1969 $200 1970 $200 1971 t=4 -$200 According to Lockheed testimony, the production phase was to run from the end of 1971 to the end of 1977, with about 210 Tri Stars as the planned output. At that production rate, the average unit production cost would be about $14 million per aircraft. The inventory-intensive production costs would be relatively front-loaded, so that the $490 million ($14 million per plane, 35 planes per year) annual production costs can be assumed to occur in six equal increments at the end of years 1971-1976 (t=4 through t=9). Revenues In 1968, the expected price to be received for the L-1011 Tri Star was about $16 million per aircraft. These revenue flows would be characterized by a lag of a year to the production cost outflows, annual revenues of $560 million can be assumed to occur in six equal increments at the end of years 1972-1977 (t5 through 10). Inflation-escalation terms in the contracts ensured that any future inflation-based cost and revenue increases offset each other nearly exactly, thus providing no incremental net cash flows. In 1968, the expected price to be received for the L-1011 Tri Star was about $16 million per aircraft. These revenue flows would be characterized by a lag of a year to the production cost outflows; annual revenues of $560 million can be assumed to occur in six equal increments at the end of years 1972-1977 (t=5 through tw10). Inflation-escalation terms in the contracts ensured that any future inflation-based cost and revenue increases offset each other nearly exactly, thus providing no incremental net cash flows. Deposits toward future deliveries were received from Lockheed customers. Roughly one- quarter of the price of the aircraft was actually received two years early. For example, for a single Tri Star delivered at the end of 1972, $4 million of the price is received at the end of 1970, leaving $12 million of the $16 million price as cash flow at the end of 1972. So, for the 35 planes built (and presumably, sold) in a year, $140 million of the $560 million in total annual revenue is actually received as a cash flow two years earlier. 2 Excluding preproduction cost allocations. That is, the $14 million cost figure is totally separate from the $900 million of preproduction costs shown in the table above. Investment Analysis and Lockheed Tri Star 291-031 Discount Rate Experts estimated that the cost of capital applicable to Lockheed's assets (prior to Tri Star) was in the 9%-10% range. Since the Tri Star project was quite a bit riskier (by any measure) than the typical Lockheed operation, the appropriate discount rate was almost certainly higher than that Using 10% should give a reasonable (although possibly generous) estimate of the project's value. Break-Even Revisited In an August 1972 Time magazine article, Lockheed (after receiving government loan guarantees) revised its break-even sales volume: "[Lockheed] claims that it can get back its development costs about $960 million) and start making a profit by selling 275 Tri Stars." Industry analysts had predicted this actually, they had estimated 300 units to be the break-even volume) even prior to the Congressional hearings. Based on a "learning curve" effect, production costs at these levels would average only about $12.5 million per unit, instead of $14 million as above. Had Lockheed been able to produce and sell as many as 500 aircraft, this average cost figure may have been even as low as $11 million per aircraft. Lockheed had testified that it had originally hoped to capture 35%-40% of the total free-world market of 775 wide bodies over the next decade (270-310 aircraft). This market estimate had been based on a wildly optimistic assumption of 10% annual growth in air travel; at a more realistic 5% growth rate, the total world market would have been only 323 aircraft. The Tri Star's actual sales performance never approached Lockheed's high expectations. Lockheed's share price plummeted from a high of about $70 to around $3 during this period. There were about 11.3 million shares of Lockheed common outstanding during this period. Exhibit 1 contains additional information on Lockheed's common stock. Value Added? As concerns the economic viability of the Tri Star program, there are several interesting points to consider: Al plamed (210 units) production levels, what was the true value of the Tri Star program? At a "break-even" production of roughly 300 units, did Lockheed really break even in value terms? At what sales volume did the Tri Star program reach true economic (as opposed to accounting) break-even? Was the decision to pursue the Tri Star program a reasonable one? What were the effects of this project" on Lockheed shareholders? 4. You are the CEO of Valu-Added Industries, Inc. (VAI). Your firm 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 $1,000,000 Equity Assets $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 value of the stock of the existing shareholders, if any? Lockheed Tri Star and Capital Budgeting In 1971, the American firm Lockheed found itself in Congressional 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 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. 291-031 Investment Analysis and Lockheed Tri Star The debate over the viability of the program centered on estimated "break-even sales" the number of jets that would need to be sold for total revenue to cover all accumulated costs. Lockheed's CEO, in his July 1971 testimony before Congress, asserted that this break-even point would be reached at sales somewhere between 195 and 205 aircraft. At this point, Lockheed had secured only 103 firm orders plus 75 options-to-buy, but they testified that sales would eventually exceed the break-even point and that the project would thus become "a commercially viable endeavor." Costs The preproduction phases of the Tri Star project began at the end of 1967 and lasted four years, after running about six months behind schedule. Various estimates of the up-front costs ranged between $800 million and $1 billion. A reasonable approximation of these cash outflows would be $900 million, occurring as follows: End of Year Time "Index" Cash Flow ($mm) 1967 -$100 1968 -$200 1969 $200 1970 $200 1971 t=4 -$200 According to Lockheed testimony, the production phase was to run from the end of 1971 to the end of 1977, with about 210 Tri Stars as the planned output. At that production rate, the average unit production cost would be about $14 million per aircraft. The inventory-intensive production costs would be relatively front-loaded, so that the $490 million ($14 million per plane, 35 planes per year) annual production costs can be assumed to occur in six equal increments at the end of years 1971-1976 (t=4 through t=9). Revenues In 1968, the expected price to be received for the L-1011 Tri Star was about $16 million per aircraft. These revenue flows would be characterized by a lag of a year to the production cost outflows, annual revenues of $560 million can be assumed to occur in six equal increments at the end of years 1972-1977 (t5 through 10). Inflation-escalation terms in the contracts ensured that any future inflation-based cost and revenue increases offset each other nearly exactly, thus providing no incremental net cash flows. In 1968, the expected price to be received for the L-1011 Tri Star was about $16 million per aircraft. These revenue flows would be characterized by a lag of a year to the production cost outflows; annual revenues of $560 million can be assumed to occur in six equal increments at the end of years 1972-1977 (t=5 through tw10). Inflation-escalation terms in the contracts ensured that any future inflation-based cost and revenue increases offset each other nearly exactly, thus providing no incremental net cash flows. Deposits toward future deliveries were received from Lockheed customers. Roughly one- quarter of the price of the aircraft was actually received two years early. For example, for a single Tri Star delivered at the end of 1972, $4 million of the price is received at the end of 1970, leaving $12 million of the $16 million price as cash flow at the end of 1972. So, for the 35 planes built (and presumably, sold) in a year, $140 million of the $560 million in total annual revenue is actually received as a cash flow two years earlier. 2 Excluding preproduction cost allocations. That is, the $14 million cost figure is totally separate from the $900 million of preproduction costs shown in the table above. Investment Analysis and Lockheed Tri Star 291-031 Discount Rate Experts estimated that the cost of capital applicable to Lockheed's assets (prior to Tri Star) was in the 9%-10% range. Since the Tri Star project was quite a bit riskier (by any measure) than the typical Lockheed operation, the appropriate discount rate was almost certainly higher than that Using 10% should give a reasonable (although possibly generous) estimate of the project's value. Break-Even Revisited In an August 1972 Time magazine article, Lockheed (after receiving government loan guarantees) revised its break-even sales volume: "[Lockheed] claims that it can get back its development costs about $960 million) and start making a profit by selling 275 Tri Stars." Industry analysts had predicted this actually, they had estimated 300 units to be the break-even volume) even prior to the Congressional hearings. Based on a "learning curve" effect, production costs at these levels would average only about $12.5 million per unit, instead of $14 million as above. Had Lockheed been able to produce and sell as many as 500 aircraft, this average cost figure may have been even as low as $11 million per aircraft. Lockheed had testified that it had originally hoped to capture 35%-40% of the total free-world market of 775 wide bodies over the next decade (270-310 aircraft). This market estimate had been based on a wildly optimistic assumption of 10% annual growth in air travel; at a more realistic 5% growth rate, the total world market would have been only 323 aircraft. The Tri Star's actual sales performance never approached Lockheed's high expectations. Lockheed's share price plummeted from a high of about $70 to around $3 during this period. There were about 11.3 million shares of Lockheed common outstanding during this period. Exhibit 1 contains additional information on Lockheed's common stock. Value Added? As concerns the economic viability of the Tri Star program, there are several interesting points to consider: Al plamed (210 units) production levels, what was the true value of the Tri Star program? At a "break-even" production of roughly 300 units, did Lockheed really break even in value terms? At what sales volume did the Tri Star program reach true economic (as opposed to accounting) break-even? Was the decision to pursue the Tri Star program a reasonable one? What were the effects of this project" on Lockheed shareholders