Good Investment Opportunities for Lockheed Company - Essay Example

EXECUTIVE SUMMARY Today every organization and individual is looking for good investment opportunities that will result in profitable cash flows in future. But the main issue is how can we decide which investment is best for us. The answer to this query is in the investment analysis and the methods that are used in capital budgeting. The capital budgeting techniques includes Net Present Value method, internal rate of return method and payback period. Every method has its own pros and cons which are used in different scenarios. This case has highlighted the use of the different capital budgeting methods. At times, there are different other factors apart from these budgeting methods, which should also be kept in mind while making decision. Because when we talk about investment there are two major components; return and risk. The budgeting method used in the cases will help the decision maker in critically analyzing all the available alternatives and choosing the best among them, so that they can achieve profitable cash flows in future. Introduction Investment is defined as present commitment of dollar for a specific tenure in order to generate future stream of cash flows which will be greater than current dollar amount1. The investor can be an individual, an organization, a government or a pension fund. In addition to this, investor expects a rate of return on the investment as compensation for the time for which they have made investment2. However, there might be some deviation from expected rate of return from certain investments and such deviation is known as investment risk. Therefore, where there is investment there is return and risk. Investment can be of two types; financial investment and economic investment. A financial investment refers to commitments in terms of monetary terms in order to generate better future cash flows which can be in a form of interest, premium, dividend etc. However, economic investment refers to making fund commitment which will result in increase of capital stock which includes goods and services. Furthermore, investors are looking for investment opportunities that will increase the current pool of funds in future. Hence, investment analysis refers to finding and opting for investment opportunity that will be giving highest rate of return and is having minimum risk. Thus, investors needs to evaluate all the available investment options and should come up with the best possible scenario3. Organizations encounter many investment opportunities but the main issue is opting and evaluating the options. Therefore, the decision maker would want to go for an opportunity that will give them highest rate of return. Now, the management has to evaluate all the available options and the best method to evaluate the options is by using Net present Value method. According to Needles, Powers and Crosson, Net Present Value (NPV) method evaluates the initial capital investment by discounting the future cash flows to their present value and also subtracting the initial investment amount from the sum. Thus, the investment opportunities having highest net present value (NPV) is the most suitable option as it depicts that future return on this investment will be maximum in comparison to other investment opportunities4. Similarly another method to evaluate rate of return from an investment or project is through Internal Rate of Return (IRR). This method is similar to the Net present value (NPV) but the results are mentioned in percentage format. The internal rate of return should exceed required rate of return that is set by the decision makers for the investment option. These methods will help the decision maker in deciding on the investment opportunity which will give the highest rate of return for the said of initial investment. DATA ANALYSIS The data was taken from Harvard Business school case, “Investment Analysis and Lockheed Tri star (1993). The case included four different case studies which were to be evaluated in accordance to the criteria defined in the case. Different financial methods were used in order to find solution to the problems mentioned in the case. The method used to evaluate the investment options are as follows5. Net present value calculation Net present value is one of the methods that is used to evaluate the investment opportunity if it will be a profitable investment or not. NPV is calculated using following formula  Where, NPV= net present value; Ct = net cash inflow for the period t; Co = initial investment; r = discount rate and t = number of time periods However, in case of perpetuity where cash flows are constant having same cash flows every year, than the formula is modified;  Where C=cash flows and r =discount rate If NPV is greater than 0 then investment should be done while if NPV is less than zero then investment should not be made6. Internal rate of return calculation Internal rate of return (IRR) is another method that is also used to evaluate the profitability of reinvestment but is expressed in percentage format. In this method, rate is to be identified at which the present value is equal to initial investments. Therefore, IRR is calculated as Where IRR= Internal rate of return; Ct = net cash inflow for the period t; Co = initial investment and t = number of time periods. For an investment to be profitable, IRR should be greater than the required rate of return (hurdle rate)7. Payback period calculation The payback period of the project is the length of time required to recoup the initial investment on the project and is calculated as8; Accounting rate of return calculation The above mentioned investment analysis and capital budgeting techniques focused on the cash flows of the projects but the accounting rate of return calculation is based on using expected operating income that will be generated from the project. The formula for using accounting rate of return (ARR) is; If the Accounting rate of return (ARR) is equal to or greater than management’s required rate of return then the project is accepted and if ARR is less than required rate of return then the project is rejected (Megginson & Smart, 2008). RESULTS 1. Rainbow Products Part A9 Rainbow Products intends to purchase paint-mixing machine which will reduce their labor cost. But the results have shown that the Net Present Value (NPV) is -$946 which is negative thus depicting that outflows will be more than initial investment even after 15 years therefore, Rainbow Products should not invest in this product. Similarly, Internal Rate of Return (IRR) has also been calculated for the paint mixing product which came out to be 11.49% which is less than the required rate of return that in our case is 12%. Hence, IRR is considered to be an indicator of quality of the investment. Therefore the Rainbow Products should not purchase the paint mixing product. The payback period of the product is 7 years which means that it will take seven years to recover the cost of paint mixing machine. Part B10 If Rainbow avails “Good as New” service contract for the paint mixing machine with additional cost of $500 then the results came out to be different. Considering perpetuity, which means equal cash flows for unlimited time period the net present value (NPV) came out to be $2,500. The NPV value is positive thus if paint mixing machine is purchased with the service then it Rainbow should make the investment. Similarly the Internal Rate of return (IRR) if availing service came out to be 12.86% which is greater than required rate of return that is 12%. Thus, Rainbow should make the investment with the service. However, if Rainbow avails the service along with the product then the payback period is slightly increased from 7 years to 7 years and 9 months. Part C11 Another option available to Rainbow is that apart from availing service contract they reinvest 20% of annual cost savings for maintenance of machine. The Net present value (NPV) was calculated to be $12,273 which clearly shows that the NPV is positive and Rainbow engineers should adopt this option. Furthermore, 15.09% Internal Rate of return is expected which is far greater than required rate of return that is 12%. The payback period in this scenario is 7 years and 7 months. 2. Concession Stand Part 112 There are four different option available that might increase the profits of concession stand and there internal rate of return (IRR) have been calculated in Table 2 of Exhibit. Decision based on IRR calculation only, the most feasible option is “renting a large stand” where the IRR is 1207.61% which is greater than the required rate of return of 15%. Therefore, I would opt renting a larger stand based on this calculation. Part 213 If Net Present Value (NPV) method is used to evaluate the options available for the investment; then based on the calculation done, the most suitable option is “building a new stand”. Its NPV is positive and highest among all the available options. The NPV of building a new concession stand is $34,825.76. Part 314 If we rank all the four options in accordance to each of the two above mentioned method we will get different preference in each case. The ranking of the four available options in accordance to calculation based on NPV method is; (starting from most favorable option) I. Building a new stand : $34,825.76 II. Renting a large stand : $28,469.88 III. Adding a window : $25,461.91 IV. Updating existing equipment : $2,514.18 While the ranking of the four options in case of IRR calculation are different and as follows: (starting from most favorable option) I. Renting a large stand : 1207.61% II. Adding a window : 34.62% III. Building a new stand : 31.21% IV. Updating existing equipment : 18.01% The main difference in the rankings of NPV and IRR is because NPV takes into account value addition while IRR focuses on achieving breakeven point. Furthermore, NPV calculations are considered to be more authentic because NPV uses the discount rate that is the actual rate while IRR uses the arbitrary rate and we can achieve NPV=0 at more than one rate. For example considering the case of “renting a car” and change the initial investment as calculated in Table 2b. We will see we are just changing the initial investment using multiple of 10 and we have figured out that NPV is increasing with increase of investment amount however; IRR remains the same irrespective of the changes in investment. Therefore, IRR remaining constant shows that it is unrealistic because investment will have a considerable impact on the future cash flows as depicted through net present value (NPV). Thus, the main reason of preferring NPV is that it takes into account the initial investment while in case of IRR initial investment does not matter. 3. MBATech Inc. Part 1 The subsidy for each alternative has been calculated in Table 3. On the basis of data available, at first the subsidized initial investments for each alternative have been calculated and then the difference between the actual initial investment and the subsidized investment for the alternative is calculated and this difference is the amount of subsidy for the alternative. The subsidy amount for each alternative is as follow: A. IRR is 25% : $122,100 B. Pay back is 2 years : $256,522 C. NPV is $75,000 at 20% rate : $112,666 D. Accounting rate of return is 40% : $173,950 Part 2 According to the calculations done in Table 3 based on 20% discounted rate for each of the four options; we now have NPV for each of the four options. From MBATech perspective option B would be most suitable one. The NPV for the option B, “Subsidize the project to provide a 2 year payback” is positive as well as highest among the four options. The NPV for option B is $218,855.6. Apart from NPV value, IRR is 34.9% which is greater than the required rate of return that is 20%. But in this case we are looking from Bean City perspective, where we have to make sure that the amount of subsidy is minimum. So that Bean City has to contribute less in initial investment of the plant. Therefore, from Bean City perspective option C would be most suitable where “the project is subsidized to provide NPV of $ 75,000 at 20% discount rate”. Although the NPV is lowest among the NPV’s of the available alternative but still is positive. Thus, it will be best available option for the Bean City because subsidy amount is lowest but NPV is still positive. 4. VAI Industries Inc. Part A The Net present value of the project is calculates by taking the difference of initial investment from the present value of all the cash outflows and inflows over a specified period of time. Therefore, NPV is $210,000-$110,000=$100,000 Part B 1100 shares of common stocks must be issued to raise the required capital of $110,000 at the price of $100. Part C It will increase the shareholders’ value by $100,000. Therefore, the new project will have a positive impact 5. Lockheed Tri star Program Part A 15 At planned 210 units of production level the true value of Tri Star program is -$559.36Mio, which shows that the Tri Star program is reducing value instead of increasing value of Lockheed. Part B16 At a breakeven production of roughly around 300 units, Lockheed did not reach the breakeven level in value terms because the value created at this level is -$341Mio, which reduces the value of the firm. Part C 17 The true breakeven is 528 units of production during the span of 6 years. The reason is that the value of the project shifts from negative to positive. Moreover, the value reduces the per unit production cost from $12.5 to $11Million as the production goes above 500 units. Part D The decision was not reasonable because the NPV was negative. The negative NPV reduces the value of the firm. Therefore, the shareholder’s value has been reduced. RECOMMENDATIONS 1. Rainbow Products In the scenario of Rainbow products where we had three different investment opportunities but the one that is recommended keeping in view the results is “purchasing the paint mixing machine and reinvesting the 20% of annual cost saving in machine maintenance (part c)”. The results of this option showed most favorable outcomes regarding NPV, IRR and payback period. 2. Concession Stand In case of concession stand we had four different options which we had to evaluate in order to increase profits from the concession stand. In accordance to results, the most suitable option is building a new stand although it requires huge initial investments in comparison to other available option but the future cash flows will be maximized in this case. Therefore, profits in this case will be greater than that of all available options. 3. MBATech Inc In this case, Bean City is to choose from four available options regarding a project which has been subsidized through different methods. The best options in accordance to NPV is option B that is subsidizing the project using 2 years payback period but if consider from Bean City perspective then option C that is “subsidize the project to provide NPV of $75,000 at 20% discounted rate” because the subsidy amount is minimum in the case in comparison to the rest of the option. However, from MBAtech perspective option B would be best because it will give maximum NPV and its initial investment will be less in comparison to the rest of the alternative because the subsidy amount in case of option B is largest. 4. VAI Industries Inc. The issuance of new capital increases the shareholders’ value only if the NPV of the new project is positive. In order to increase the value of the firm, the initial investment must be reasonable enough to generate positive cash flows. 5. Lockheed Tri Star Program Lockheed needs to reduce the preproduction cost along with reasonable assumptions regarding the growth rate of production. Moreover, the reduction of accumulated cost may increase the NPV of the project provided the sales volume will also be increased. If sales volume will not be increased then the NPV may remain negative. EXHIBIT Table 1 Table 2a Table 2b Table 3 Table 5a Table 5b Table 5c References Gallagher, T. J., & Andrew, J. D. (2007). Financial Management; Principles and Practice. California: Freeload Press Inc. (1993, November 17). Investment Analysis and Lockheed Tri star. Harvard Business School.: Boston Megginson, W., & Smart, S. (2008). Introduction to Corporate Finance. London: Cengage Learning,. Needles, B., Powers, M., & Crosson, S. (2010). Principles of Accounting. New York: Cengage Learning. Ranganatham, M. (2004). Investment Analysis and Portfolio Management. New Delhi: Pearson Education India. Reilly, F., & Brown, K. (2011). Investment Analysis and Portfolio Management. Mason: Cengage Learning. Read More