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 Starprogram. The L-1011 Tri Star Airbus is a wide-bodied commercial jet aircraft with a capacity of up to400 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 thattheir problem was merely a liquidity crisis caused by some unrelated military contracts. Opposingthe guarantee, other parties argued that the Tri Star program had been economically unsound anddoomed to financial failure from the very beginning.

The debate over the viability of the program centered on estimated break-even salesthenumber of jets that would need to be sold for total revenue to cover all accumulated costs.Lockheeds CEO, in his July 1971 testimony before Congress, asserted that this break-even pointwould be reached at sales somewhere between 195 and 205 aircraft. At this point, Lockheed hadsecured only 103 firm orders plus 75 options-to-buy, but they testified that sales would eventuallyexceed the break-even point and that the project would thus become a commercially viableendeavor.CostsThe preproduction phases of the Tri Star project began at the end of 1967 and lasted fouryears, after running about six months behind schedule. Various estimates of the up-front costsranged between $800 million and $1 billion. A reasonable approximation of these cash outflowswould be $900 million, occurring as follows:

end of year	time "index"	Cash Flow ($mm)
1967	t=0	-100
1968	t=1	-200
1969	t=2	-200
1970	t=3	-200
1971	t=4	-200

According to Lockheed testimony, the production phase was to run from the end of 1971 tothe end of 1977, with about 210 Tri Stars as the planned output. At that production rate, the averageunit production cost2 would be about $14 million per aircraft. The inventory-intensive productioncosts would be relatively front-loaded, so that the $490 million ($14 million per plane, 35 planes peryear) annual production costs can be assumed to occur in six equal increments at the end of years1971-1976 (t=4 through t=9).

Revenues

In 1968, the expected price to be received for the L-1011 Tri Star was about $16 million peraircraft. These revenue flows would be characterized by a lag of a year to the production costoutflows; annual revenues of $560 million can be assumed to occur in six equal increments at the endof years 1972-1977 (t=5 through t=10). Inflation-escalation terms in the contracts ensured that anyfuture inflation-based cost and revenue increases offset each other nearly exactly, thus providing noincremental 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 TriStar delivered at the end of 1972, $4 million of the price is received at the end of 1970, leaving $12million of the $16 million price as cash flow at the end of 1972. So, for the 35 planes built (andpresumably, sold) in a year, $140 million of the $560 million in total annual revenue is actuallyreceived as a cash flow two years earlier.

Discount Rate

Experts estimated that the cost of capital applicable to Lockheeds 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 thetypical Lockheed operation, the appropriate discount rate was almost certainly higher than that.Using 10% should give a reasonable (although possibly generous) estimate of the projects value.

Break-Even Revisited

In an August 1972 Time magazine article, Lockheed (after receiving government loanguarantees) revised its break-even sales volume: [Lockheed] claims that it can get back itsdevelopment costs [about $960 million] and start making a profit by selling 275 Tri Stars.3 Industryanalysts had predicted this (actually, they had estimated 300 units to be the break-even volume) evenprior to the Congressional hearings.4 Based on a learning curve effect, production costs at theselevels would average only about $12.5 million per unit, instead of $14 million as above. HadLockheed been able to produce and sell as many as 500 aircraft, this average cost figure may havebeen even as low as $11 million per aircraft.

Lockheed had testified that it had originally hoped to capture 35%-40% of the total free-worldmarket of 775 wide bodies over the next decade (270-310 aircraft). This market estimate had beenbased 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 Stars actual salesperformance never approached Lockheeds high expectations. Lockheeds share price plummetedfrom a high of about $70 to around $3 during this period. There were about 11.3 million shares ofLockheed common outstanding during this period. Exhibit 1 contains additional information onLockheeds common stock.

Value Added?

As concerns the economic viability of the Tri Star program, there are several interestingpoints to consider.

At planned (210 units) production levels, what was the true value of the Tri Starprogram?

At a break-even production of roughly 300 units, did Lockheed really break even invalue terms?

At what sales volume did the Tri Star program reach true economic (as opposed toaccounting) break-even?

Was the decision to pursue the Tri Star program a reasonable one? What were the effectsof this project on Lockheed shareholders?

*Please show all work and formulas if used on excel/financial calculator.

thank you!