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(solution) Need help with the following case study. It is 4 problems all the


Need help with the following    case study. It is 4 problems all the data is included in the attatchment. Thanks


Harvard Business School 9-298-092 rP

 

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t Rev. December 4, 1998 Valuing Capital Investment Projects

 

1. Growth Enterprises, Inc. (GEI) has $40 million that it can invest in any or all of the four

 

capital investment projects, which have cash flows as shown in Table 1 below. op

 

yo Table 1 Comparison of Project Cash Flows* ($ thousands) Year of Cash Flow A. B. C. Year 0 Investment

 

Revenue

 

Operating expenses

 

Investment

 

Revenue

 

Operating expenses Year 3 ($10,000) Investment

 

Revenue

 

Operating expenses Year 2 ($10,000) Investment

 

Revenue

 

Operating expenses Year 1 ($10,000) ($10,000) No D. Type of

 

Cash Flow tC Project $21,000

 

11,000 $15,000

 

5,833 $17,000

 

7,833 $10,000

 

5,555 $11,000

 

4,889 $30,000

 

15,555 $30,000

 

15,555 $10,000

 

5,555 $5,000

 

2,222 * All revenues and operating expenses can be considered cash items.

 

Each of these projects is considered to be of equivalent risk. The investment will be

 

depreciated to zero on a straight-line basis for tax purposes. GEI?s marginal corporate tax Do This case was prepared as the basis for class discussion rather than to illustrate either effective or ineffective handling of an

 

administrative situation. Problem 1 appears in the case, ?Introduction to Investment Evaluation Techniques? (HBS case

 

no. 285-115) by Professor Dwight B. Crane and was revised for inclusion in this case. Problems 3 and 4 appear in the case,

 

?Investment Analysis and Lockheed Tri Star?(HBS case no. 291-031) by Professor Michael E. Edleson and were also

 

revised for inclusion in this case.

 

Copyright © 1997 by the President and Fellows of Harvard College. To order copies or request permission to

 

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t rate on taxable income is 40%. None of the projects will have any salvage value at the end of

 

their respective lives. For purposes of analysis, it should be assumed that all cash flows occur

 

at the end of the year in question. Rank GEI?s four projects according to the following four commonly used capital budgeting

 

criteria:

 

1) Payback period. 2) Accounting return on investment. For purposes of this exercise, the accounting

 

return on investment should be defined as follows:

 

Average annual after-tax profits

 

(Required investment)/2

 

Internal rate of return. 4) Net present value, assuming alternately a 10% discount rate and a 35% discount

 

rate. op

 

yo 3) B. C. If the projects are independent of each other, which should be accepted? If they are mutually

 

exclusive (i.e., one and only one can be accepted), which one is best? Electronics Unlimited was considering the introduction of a new product that was expected

 

to reach sales of $10 million in its first full year, and $13 million of sales in the second year.

 

Because of intense competition and rapid product obsolescence, sales of the new product

 

were expected to remain unchanged between the second and third years following

 

introduction. Thereafter, annual sales were expected to decline to two-thirds of peak annual

 

sales in the fourth year, and one-third of peak sales in the fifth year. No material levels of

 

revenues or expenses associated with the new product were expected after five years of sales.

 

Based on past experience, cost of sales for the new product were expected to be 60% of total

 

annual sales revenue during each year of its life cycle. Selling, general, and administrative

 

expenses were expected to be 23.5% of total annual sales. Taxes on profits generated by the

 

new product would be paid at a 40% rate. No tC 2. Why do the rankings differ? What does each technique measure and what assumptions does it

 

make? To launch the new product, Electronics Unlimited would have to incur immediate cash

 

outlays of two types. First, it would have to invest $500,000 in specialized new production

 

equipment. This capital investment would be fully depreciated on a straight-line basis over

 

the five-year anticipated life cycle of the new product. It was not expected to have any

 

material salvage value at the end of its depreciable life. No further fixed capital expenditures

 

were required after the initial purchase of equipment. Do Second, additional investment in net working capital to support sales would have to be

 

made. Electronics Unlimited generally required 27¢ of net working capital to support each

 

dollar of sales. As a practical matter, this buildup would have to be made by the beginning of

 

the sales year in question (or, equivalently, by the end of the previous year). As sales grew,

 

further investments in net working capital ahead of sales would have to be made. As sales

 

diminished, net working capital would be liquidated and cash recovered. At the end of the

 

new product?s life cycle, all remaining net working capital would be liquidated and the cash

 

recovered. 2

 

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t Finally, Electronics Unlimited expected to incur tax-deductible introductory expenses of

 

$200,000 in the first year of the new product?s sales. These costs would not be recurring over

 

the product?s life cycle. Approximately $1.0 million had already been spent developing and

 

test marketing the new product. These expenditures were also one-time expenses that would

 

not be recurring during the new product?s life cycle. B. Ass uming a 20% discount rate, what is the product?s net present value? (Except for changes

 

in net working capital, which must be made before the start of each sales year, you should

 

assume that all cash flows occur at the end of the year in question.) What is its internal rate

 

of return? C.

 

3. Estimate the new product?s future sales, profits, and cash flows throughout its five-year life

 

cycle. Should Electronics Unlimited introduce the new product? op

 

yo A. You are the CEO of Valu-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:

 

VAI Market Value Balance Sheet

 

$1,000,000 Equity Assets $1,000,000 A.

 

B. What is the net present value of this project?

 

How many shares of common stock must be issued, and at what price, to raise the required

 

capital?

 

What is the effect, if any, of this new project on the value of the stock of the existing

 

shareholders? No C. tC 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 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. 4. Lockheed Tri Star and Capital Budgeting1 Do In 1971, the American aerospace company, Lockheed, found itself in Congressional hearings

 

seeking a $250 million federal guarantee to secure bank credit required for the completion of

 

the L-1011 Tri Star program. The L-1011 Tri Star Airbus was a wide-bodied commercial jet

 

aircraft with a capacity of up to 400 passengers, competing with the DC-10 triject and the A300B 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.

 

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t 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 that 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.? Lockheed also testified that it 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 the optimistic assumption of 10% annual growth in air

 

travel. At a more realistic 5% growth rate, the total world market would have been only

 

about 323 aircraft.

 

Costs End of Year

 

1967

 

1968

 

1969

 

1970

 

1971 op

 

yo The pre-production 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 initial

 

development costs ranged between $800 million and $1 billion. A reasonable approximation

 

of these cash outflows would be $900 million, occurring as follows:

 

Time ?Index? Cash Flow ($ millions) t=0

 

t=1

 

t=2

 

t=3

 

t=4 -$100

 

-$200

 

-$200

 

-$200

 

-$200 tC 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 inventoryintensive 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 No 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. Do Deposits toward future deliveries were received from Lockheed customers. Roughly onequarter 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. 2 This figure excludes preproduction cost allocations. That is, the $14 million cost figure is totally separate from the $900 million of preproduction costs shown in the table above. 4

 

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t Valuing Capital Investment Projects 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 op

 

yo 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 breakeven 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.

 

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? B. At ?break-even? production of roughly 300 units, did Lockheed break even in terms of net

 

present value? C. At what sales volume would the Tri Star program have reached true economic (as opposed to

 

accounting) break-even? D. 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? Do No tC A. 3 Time (August 21, 1972), 62.

 

4 Mitchell Gordon, ?Hitched to the Tri Star?Disaster at Lockheed Would Cut a Wide Swathe,? Barron?s (March 15, 1971), 5-14. 5

 

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