Tristar Case Sol.

Case #2 Investment analysis and Lockheed Tri Star 104282771 January 21st, 2019 1. Rainbow Products is considering the purchase of a paint-mixing machine to reduce labor costs. The savings are expected to result in additional cash flows to Rainbow of $5,000 per year. The machine costs $35,000 and is expected to last for 15 years. Rainbow has determined that the cost of capital for such an investment is 12%. a. [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. i. Payback period : $35,000 / $5,000 = 7 years Then once discount rate of 12% is applied payback period becomes 16.2 years ii. Calculating NPV:

1. 2. 3. 4.

-35,000 (purchase of machine) I/yr = 12% N = 15 NPV = $-945.68

iii. Calculating IRR:

The calculation was achieved using the IRR function with the cashflows assigned by the question. [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?

Using the same metrics as Q1, rainbow products should indeed buy the service contract as it creates value. This is demonstrated through the positive NPV and finally the IRR is greater than the initial discount rate.

[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. For example, at the end of year one, 20% of the $5,000 cost savings ($1,000) is reinvested in the machine; the net cash flow is thus $4,000. Next year, the cash flow from cost savings grows by 4% to $5,200 gross, or $4,160 net, of the 20% reinvestment. As long as the 20% reinvestment continues, the cash flows continue to grow at 4% in perpetuity. What should Rainbow Products do?

Therefore Rainbow products should do this investment. This is investment is in the company’s best interest as it has a positive NPV and the IRR is once again more than the stated discount rate.

Q2 • Using the internal rate of return rule (IRR), which proposal(s) do you recommend? • Using the net present value rule (NPV), which proposal(s) do you recommend? • How do you explain any differences between the IRR and NPV rankings? Which rule is better?

Project 4 is the best investment in terms of return on investment however project 3 is seems to be more valuable long term as the NPV is higher than any other prospective investments.

In the end NPV should be the deciding metric to rely upon. Therefore project 3 [build a new stand] is the best investment. NPV is the most reliable metric as it indicates the most value derived from a project over the life of the project. IRR is less relevant in these cases as there are varying degrees in the investment size and is not effective in comparing projects with different initial investment sizes. NPV in contrast considers the size of the cash flows relative to the investment size.

Q3

Q4 You then discover an opportunity to invest in a new project that produces positive cash flows with a present value of $210,000. Your total initial costs for investing and developing this project are only $110,000. 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. • What is the Net Present Value of this project? • How many shares of common stock must be issued (at what price) to raise the required capital? • What is the effect of this new project on the value of the stock of the existing shareholders, if any?

Case study Lockheed Tri Star and Capital Budgeting Q: 210 units produced cashflows

Q: 300 units sold over 6 years of production

Lockheed did not breakeven in terms of value. This is demonstrated through the negative NPV. Even though it is an improvement from the last production level it is still not create enough value to make it worth the company’s time.

Q: was the decision reasonable to pursue Tri Star Program? What were the effect on shareholders? The decision was absolutely terrible. All metrics above indicate a negative value for the project. The NPV was negative at both levels of production and increasing production would probably not be feasible or even realistic. As for share price: SP in 1967: $70 SP in 1974: $3 Total shares 11.39 Mil Shareholder value = ($70 - $3) x 11.39 = 763.13 million Therefore the shareholder value declined by 763.13 million dollars!