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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




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




Operating expenses






Operating expenses Year 3 ($10,000) Investment




Operating expenses Year 2 ($10,000) Investment




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


reproduce materials, call 1-800-545-7685 or write Harvard Business School Publishing, Boston, MA 02163. No


part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in


any form or by any means?electronic, mechanical, photocopying, recording, or otherwise?without the


permi ssion of Harvard Business School. 1


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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




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




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










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=4 -$100








-$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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