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: 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 cost2 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 ( t=5 through t=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. Lockheed Tri Star and Capital Budgeting1 In 1971, the American firm Lockheed found itself in Congressional hearings seeking a \$250million 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. LOCKHEED, INC. COMMON STOCK Monthly Prices, 1967-1973 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." 3 Industry analysts had predicted this (actually, they had estimated 300 units to be the break-even volume) even prior to the Congressional hearings. 4 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: 5 - At planned (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? 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: 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 cost2 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 ( t=5 through t=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. Lockheed Tri Star and Capital Budgeting1 In 1971, the American firm Lockheed found itself in Congressional hearings seeking a \$250million 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. LOCKHEED, INC. COMMON STOCK Monthly Prices, 1967-1973 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." 3 Industry analysts had predicted this (actually, they had estimated 300 units to be the break-even volume) even prior to the Congressional hearings. 4 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: 5 - At planned (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