The Investment Analysis and Lockheed Tri Star case study provides the opportunity for students to come up with calculations on NPV and IRR for capital investment projects.
Michael E. Edleson
Harvard Business Review (291031-PDF-ENG)
February 27, 1991
Case questions answered:
- 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 cash 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 - A. Using the internal rate of return rule (IRR), which proposal(s) do you recommend?
B. Using the net present value rule (NPV), which proposal(s) do you recommend?
C. How do you explain any differences between the IRR and NPV rankings? Which rule is better? - You have been hired by Bean City to recommend a subsidy that minimizes costs for the city. Payments do not have to be made immediately. They can be programmed whenever it best suits the city. Which one of the four proposals would you recommend if the applicable discount rate is 20%?
- New investment opportunity generates positive CFs with a PV of $210,000. Initial required investment = 110,000. Will raise necessary capital with new shares. All potential buyers of shares are fully aware of the value and cost of the project and are willing to pay “fair value” for the new ordinary shares of VAI. Which is the NPV of the project?
- A. At planned (210 units) production levels, what was the true value of the Lockheed Tri Star program?
B. At a “break-even” production of roughly 300 units, did Lockheed really break even in value terms?
C. At what sales volume did the Tri Star program reach true economic (as opposed to accounting) break-even?
D. Was the decision to pursue the Tri Star program a reasonable one? What were the effects of this “project” on Lockheed shareholders?
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Case answers for Investment Analysis and Lockheed Tri Star
This case solution includes an Excel file with calculations.
1A. 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.
PAYBACK PERIOD – Lockheed Tri Star machine only
NET PRESENT VALUE
INTERNAL RATE OF RETURN
1B. 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 cash flows of $4,500 per year in perpetuity. Should Rainbow Products purchase the machine with the service contract?
PAYBACK PERIOD
Flow reduced by $500 each period and are a perpetuity instead of an annuity
*As the problem states the contract will maintain the machine as good as new forever, we use the formula for perpetuity
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