Rainbow Products
 Purchasing a paint mixer machine for estimated additional cash flows of
$5000 a year for the next 15 years
 Initial Cost will be $35000
 Determined Cost of Capital to be 12%
 So: CF= $5000 per year
 T= 15 years
 Initial Outlay=-$35000
 K=12%

 Assuming there are no taxes
 Payback Period: time required for the
amount invested into the project to
be repaid by the cash flows
generated from the project
 $35000 initial investment/$5000
annual cash flow = 7 years
 Advantage: It is very simple and easy
to use
 Disadvantage: Does not take into
account the time value of money

• Net Present Value of Money: the difference between the
present value of cash inflows and the present value of cash
outflows
where t= period of time, C= cash flow,
r=cost of capital
• NPV= ($5,000/(1.12^1)+…+$5,000/(1.12^15))-$35,000= -
$945.68
• If NPV> $0, then you accept the project
• Benefit: NPV is often looked at as the best tool to use when
analyzing investments

 IRR= Internal Rate of Revenue=
the interest rate that is required
to bring NPV to equal zero.
Also known as the discount
rate.
 Generally accept the project if
IRR> CoC
 IRR of paint machine= 11.49%
< 12% (CoC)
 Based on negative NPV and a
small IRR, Rainbow Products
should go through with the
project

Alternate 1
 “Good as New Expenditure” costs
$500 to keep the machine in new
condition forever
 New Cash Flow is $4500 per year
 Instead of a time period of 15
years, the project is now a
perpetuity
 NPV= (CF/r)- Initial Outlay
 NPV= ($4500/.12)-$35000= $2500
 IRR= 12.86%> 12%
 This is a profitable option for
Rainbow Products, they should
accept.

Alternate 2
 Now Reinvesting 20% back
into new machine parts,
causing cash flows to grow
at 4% indefinitely
 NPV= (CF/r-g)-Initial Outlay
 NPV= $15000
 IRR= 15.43%
 This alternate is even better
for Rainbow Products

HOT DOGS, PEANUTS,
POPCORN, BEER
Suppose you own a concession stand that sells hot dogs, peanuts,
popcorn, and beer at a ball park.You have three years left on the
contract with the ball park, and you do not expect it to be
renewed.Long lines limit sales and profits. You have developed four
different proposals to reduce the lines and increase profits.

FIRST PROPOSAL
The first proposal is to renovate by adding another window.
The second is to update the equipment at the existing windows.
These two renovation projects are not mutually exclusive; you
could take both projects. The third and fourth proposals involve
abandoning the existing stand.The third proposal is to build a
new stand. The fourth proposal is to rent a larger stand in the
ball park. This option would involve $1,000 in up-front
investment for new signs and equipment installation the
incremental cash flows shown in later years are net of lease
payments.

You have decided that a 15% discount rate is appropriate for this
type of investment. The incremental cash flows associated with each of
the proposals are:
Incremental Cash Flows
Project Investment Year 1 Year 2 Year 3
Add a New
Window
-$75,000 44,000 44,000 44,000
Update Existing
Equipment
-50,000 23,000 23,000 23,000
Build a New
Stand
-125000 70,000 70,000 70,000
Rent a Larger
Stand
-1,000 12,000 13,000 14,000

1 Using the internal rate of return rule (IRR),
which proposal(s) do you recommend?|
2 Using the net present value rule (NPV),
which proposal(s) do you recommend?|
3
How do you explain any differences
between the IRR and NPV rankings?
Which rule is better?
|
IRR vs NPV

Using the internal rate of return rule (IRR), which
proposal(s) do you recommend?
Project 1: IRR=34.61907%
So, choose Project 4.
1

Using the net present value rule (NPV), which
proposal(s) do you recommend?
Project 1: NPV=$25,462
So, choose Project 3.
2

How do you explain any differences between the
IRR and NPV rankings? Which rule is better?
Incremental Cash Flows
Project Investment Year 1 Year 2 Year 3 IRR NPV
Add a New
Window
-$75,000 44,000 44,000 44,000 34.61907% $25,462
Update
Existing
Equipment
-50,000 23,000 23,000 23,000 18.01033% $2,514
Build a
New Stand
-125000 70,000 70,000 70,000 31.20859% $34,826
Rent a
Larger
Stand
-1,000 12,000 13,000 14,000 1207.606% $28,470
3

MBATech INC. Bean City
 Some Information
 We are hired by the mayor of Bean City
 The city has agreed to subsidize MBAT
 Subsidize- A benefit given by the government to groups or individuals usually
in the form of a cash payment or tax reduction. The subsidy is usually given to
remove some type of burden and is often considered to be in the interest of
the public.
 MBATech, Inc. has given us 4 choices

MBATech INC. Bean City: Original CF
 Cash Flows
 P0- ($1,000,000)
 P1- $371,739
 P2- $371,739
 P3- $371,739
 P4- $371,739
 Discount Rate 20%
 NPV (37666.4)
 -$1,000,000 + (371739/1.2) +
(371739/1.2^2) + (371739/1.2^3) +
(371739/1.2^4)
 IRR 18%

MBATech Inc. Bean City
 MBATech Inc. Proposed 4 proposal
A. Subsidize their project to bring its IRR to 25%
B. Subsidize their project to provide two-year payback
C. Subsidize the project to provide an NPV of $75,000 when cash flows are
discounted at 20%
D. Subsidize their project to providing an accounting rate of return (ARR) of 40%.
 Quick Note: ARR= (Average Annual Cash Flow-(Investment/# of
years))/(Investment/2)
 We are here to recommend a subsidy that minimize costs to the city

 In order for their project to reach its IRR goal to 25% from 18%
 We use the Original CF, but we input I as 25% in order to get NPV -$122101.18
 We give a subsidy of $122,101.18 at Year 0.
 Outcome IRR has increase 7%, reaching its goal of 25%
 Recall the different NPV between original Cash flow and plan A
 If we put $122,101.8 in Future Value of 4 years, it equals 298098. Based on this
logic, we could either give a subsidy at year 0, decreasing MBAT initial cost to
$877898.82 or we could give the future value of $298098 at year 4. Both
corresponds to IRR at 25%.

MBATech. Inc. Bean City
How much is
needed
-$1,000,000 + Subsidy
=371739*2
-$256522
$256522 worth of subsidy should be
given at year 0 in order to achieve a 2
year payback period.
Time value of
Money
If the City give the subsidy at year
0, the PV for this subsidy is the
same since it’s not discounted.
However, if we wait till year 2 to
pay the same subsidy as promised,
the PV for that cash flow is
discounted. Meaning PV for the
same amount of money at year 2,
cost less than year 0.
Look at the chart!
2 Year Payback
The table giving the same subsidy
at different time
Year 0 Year 1 Year 2
Discount
Rate
PV at Year 0
$
256,522.00
$ - $ - 20% $256,522.00
$ - $ 128,261.00 $128,261.00 20% $195,954.31
$ - $ - $256,522.00 20% $178,140.28

 MBATech Inc. proposed NPV of $75,000 when CF are discounted at 20%
 We calculate NPV value for original, it was -$37666.4 In order to achieve
NPV $75,000. $75,000-(-37666.4) which is the subsidy at year 0, 112,666.4
 FV of 233,625.05 would be the same as giving 112,666.4 at year 0.
Year 0 Year 1 Year 2 Year 3 Year 4 Discount Rt
$ (1,000,000.00) $ 371,739.00 $ 371,739.00 $371,739.00 $371,739.00 20%
Discounted $ (1,000,000.00) 309782.5 258152.0833 215126.7361 179272.2801
Total $ $ (37,666.40)
NPV TGT $75,000 Subsidy $112,666.40
Sub at YR 0 ($887,333.60) 371739 371739 371739 371739 20%
NPV $75,000.00
FV of Sub $ 233,625.05 1122666.4*(1+.2)^4
Sub at YR 4 $ (1,000,000.00) 371739 371739 371739 605364.048 20%
NPV $ 75,000.00

MBATech, Inc. Bean City
 Subsidized their project to achieve
Accounting Rate of Return 40%.
 Definition: divides the average profit
by the initial investment in order to
get the ratio or return that can be
expected.
 http://www.investopedia.com/terms/a
/arr.asp
 Formula:
 ARR=(Average Annual Cash Flow-
(Investment/# of years))/(Investment/2)
 .4=(371739/1)-[(1,000,000+Sub)/4]/
[(1000000-Sub)/2]
 Subsidy= $173,913.33
 Again, Subsidy is given at Year 0

MBATech, Inc. Bean City
 Discount Rate at 20%
 We discount all NPV at 20% over four
years, as in NPV/(1+.2)^4
 Plan A:$122,101.18/(1.2)^4=
 Plan B:$256,522/(1.2)^4=
 Plan C:$112,666.4/(1.2)^4=
 Plan D:$173,913.33
 Based on NPV subsidy along, we
would have chosen Plan C.
 Discounted Subsidy
 Plan A:$58,883.67
 Plan B:$123,708.53
 Plan C:$54,333.72
 Plan D:$83,870.24
 Basically, we will pick the lower
subsidy. The lower it is, the less we
have to pay.
 Discounted, we will pick Plan C.

VALUE-ADDED INDUSTRIES, INC.
YOU ARE THE CEO OF VALUE-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 APPEARS AS FOLLOWS:

You then discover an opportunity to invest in a new
project that produces positive net cash flows with
a present value of $210,000. Your initial costs for
investing and developing the project are only $110,00.
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.

Let’s summarize our information
 Total existing asset
 Liabilities + Equity= $0+$1,000,000=$1,000,000
 New Project
 Cash flows: PV= $210,000
 Initial costs: $100,000
Now we need to raise additional capital for our new investment.

 What is the net present value of this project?
NPV= PV of Cash Inflows- PV of Cash
Outflows
= $210,000-$100,000
= $110,000
 The net present value of this project is $110,000.

 How many shares of common stock must be issued, and at what
price, to raise the required capital?
 The equity and total asset of the company changes. Therefore,
the market price also changes.

 We assume that we will issue n additional shares of stocks at
price p to raise capital
 n*p=$110,000
 Total asset= Equity + Cash Inflows of project
=$1,000,000+$210,000
=$1,210,000
 Total asset = (n+10,000) *p
=n*p+10,000p=$1,210,000
 n*p=$110,100 => 10,000p=$1,100,000
p= 1,100,000/10,000= $110
n=110,000/110= 1,000 shares
 Therefore, the company should issue 1000 shares of stocks at
price $110.

 Or, we can use formula directly.
 P= (old equity value+ New project’s NPV)/ old #of
shares
= (1,000,000+ 100,000)/ 10,000
=$110
 n*p= $110,000 => n=110,000/110=1000 shares

 What is the effect, if any, of this new project on the value of the stock of
the existing shareholders?
 The old price of stocks is $100.
$1,000,000/10,000=$100
 Now the price increases to $110.
 Existing shareholders will get extra $10 from each share they have.

 Investment Analysis and Lockheed Tri Star
LOCKHEED TRI STAR and CAPITAL
BUDGETING

L-1011 Tri Star Airbus commercial jet aircraft; capacity of up 400 passengers.
Competitors: DC-10 trijet and the A-300B

Capital Budgeting
The process in which a business determines whether projects such as building a new
plant or investing in a long-term venture are worth pursuing. (Investopedia)

Net Present Value (NPV) is the difference between the present value of cash inflows and
the present value of cash outflows.
Where:
Ct = net cash inflow during the period t
Co = total initial investment costs
r = discount rate, and
t = number of time periods
Source: Investopedia http://www.investopedia.com/terms/n/npv.asp#ixzz3p8drCDDl

Problem Identification:
Lockheed searches a federal guarantee for its Tri Star program for $250 million due to liquidity crisis. But the firm
considers itself “economically sound.”
Others opposed to the guarantee claim:
“Tri Star program had been economically unsound and condemned to financial failure”
Discussion of viability,
The program should be estimated on “break-even sales”
Lockheed’s CEO – Congress July 1971
“This break-even point would be reached at sales somewhere between 195 and 205 aircraft”
“… sales would eventually exceed the break-even point … , [becoming] a commercially viable endeavor”

Value Added? (a)
At planned (210 units) production levels, what was the
true value of the Tri Star program?
r = 10%
NPV = $ - 584.85 M
IRR = - 9.09 %, NPV = 0

Lockheed Tri Star - Capital Budgeting
Federal Guarantee 250 million
Investment (Preproduction outflows) 1967-1971 period
Production outflows 1971-1976 period
Revenue inflows 1972-1977 period
Average production cost 14 million
Revenue per aircraft 16 million
Before Guarantee 210 aircrafts
t = 0 t = 1 t = 2 t = 3 t = 4 t = 5 t = 6 t = 7 t = 8 t = 9 t = 10
1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977
Investment (pre-production) (100.00) (200.00) (200.00) (200.00) (200.00)
Average Production Cost (490.00) (490.00) (490.00) (490.00) (490.00) (490.00)
Revenues 420.00 420.00 420.00 420.00 420.00 420.00
Deposits toward future deliveries 140.00 140.00 140.00 140.00 140.00 140.00
Cash Flow (100.00) (200.00) (200.00) (60.00) (550.00) 70.00 70.00 70.00 70.00 (70.00) 420.00
Time "Index"
Years

Value Added? (b)
At a “break-even” production of roughly 300 units, did
Lockheed really break even in value terms?
r = 10%
NPV = $ - 274.38 M
IRR = 2.38%, NPV = 0

Average production cost 12.5 million
Before Guarantee 300 aircrafts
t = 0 t = 1 t = 2 t = 3 t = 4 t = 5 t = 6 t = 7 t = 8 t = 9 t = 10
1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977
Revenues 600.00 600.00 600.00 600.00 600.00 600.00
Cash Flow (100.00) (200.00) (200.00) - (625.00) 175.00 175.00 175.00 175.00 (25.00) 600.00
Time "Index"
Years

Value Added? (c)
At what sales volume did the Tri Star program reach the
true economic (as opposed to accounting) break-even?
The Tri Star program reached the true economic break-even (NPV) to a level of 420
aircrafts produced.

ECONOMIC BREAK-EVEN ACCOUNTING BREAK-EVEN
The difference is the opportunity cost or discount rate [hurdle rate]

Production aircraft (units) 420 aircrafts
Time "Index" t = 0 t = 1 t = 2 t = 3 t = 4 t = 5 t = 6 t = 7 t = 8 t = 9 t = 10
Years 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977
Revenues 840.00 840.00 840.00 840.00 840.00 840.00
Cash Flow (100.00) (200.00) (200.00) 80.00 (760.00) 280.00 280.00 280.00 280.00 - 840.00
IRR = 10.58%
Discount Rate = 10%
Whole free-world market = 775 aircrafts
Captured free-world market = 35% - 40%
Captured free-world market (units) = 310 aircrafts (max.)
420 aircraft produced > 310 aircraft sold

Production aircraft (units) 500 aircrafts
Time "Index" t = 0 t = 1 t = 2 t = 3 t = 4 t = 5 t = 6 t = 7 t = 8 t = 9 t = 10
Years 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977
Revenues 1,000.00 1,333.33 1,333.33 1,333.33 1,333.33 1,333.33
Cash Flow (100.00) (200.00) (200.00) 133.33 (491.67) 708.33 1,041.66 1,041.66 1,041.66 708.33 1,333.33
IRR = 45.71%
Discount Rate = 10%
Whole free-world market = 775 aircrafts
Captured free-world market = 35% - 40%
Captured free-world market (units) = 310 aircrafts

Value Added? (d)
- Was the decision to pursue the Tri Star program a reasonable one?
No, it was not a reasonable one because its NPV was negative to IRR of 10%.
- What were the effects of this “project” on Lockheed shareholders?
The effects of this “project” were negative. The common stock prices went
down from $70 per share in 1967 to $3.25 in 1974.

Presentation Case Tri Star - Final

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