Lockheed Tri Star and Capital Budgeting1 In 1971, the American aerospace company, Lockheed, found itself in Congressional hearings seeking a $250

19671968196919701971

Time "Index"

t=0 t=1 t=2 t=3 t=4

Cash Flow ($ millions)

-$100 -$200 -$200 -$200 -$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.2 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 could be assumed to occur in six equal increments at the end of years 1971 through 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 could be assumed to occur in six equal increments at the end of years 1972 through 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 flow.

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 was 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 was actually received as a cash flow two years earlier. 

Discount Rate

Experts estimated that the cost of capital applicable to Lockheed's cash flows (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. Thus, 10% was a reasonable (although possibly generous) estimate of the appropriate discount rate to apply to the Tri Star program's cash flows.

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 (up to 300 units) 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 might even have been as low as $11 million per aircraft.

1. At originally planned production levels (210 units), what would have been the estimated value of the Tri Star program as of the end of 1967?
2. At "break-even" production of roughly 300 units, did Lockheed break even in terms of net present value?
3. At what sales volume would the Tri Star program have reached true economic (as opposed to accounting) break-even?
4. Was the decision to pursue the Tri Star program a reasonable one? What effects would you predict the adoption of the Tri Star program would have on shareholder value?