How a Large Company Spiraled Out on Auto-Pilot and Should Have Ejected from the Beginning: An MBA Case Study by Michael V. Blumeyer

How a Large Company Spiraled Out on Auto-Pilot and Should Have Ejected from the Beginning

Michael V. Blumeyer

Began January 25th, 2014; Completed January 26, 2014

Executive Summary

Lockheed Martin, an American firm in the aircraft industry, took the initiative to craft a strategy to complete the L-1011 Tri Star program.  One competitive advantage that the Tri Star Airbus possesses is its massive capacity to store up to 400 passengers, thus able to potentially compete with the DC-10 trijet and the A-300B airbus.  Lockheed Martin overlooked multiple expenses that were not properly identified as they tried to secure a $250 million guarantee from the government.  These negative expenses caused challenges in the firm’s ability to stay true to shareholder expectations, which caused the stock price in 1969 to plummet from $64 in January of 1967, to $11 in January of 1971.

The main point of the case is to understand how important it is to examine the net present value (NPV) of a company.  For this firm, the managerial decisions from analysts that were risk-seeking to aggressively expand their capital structure leverage while simultaneously avoiding the fact that they were not currently a global leader in the market resulted in severe financial consequences for the firm.  In addition, this case demonstrates the negative results that manifests when a group does not greatly value rational decision-making.  Even though the firm began with literally hundreds of thousands of dollars when initiating costs, the firm believed that it had the capital to overcome any challenge and that the rules of behavioral finance did not apply to them.  The NPV analysis and negative cash flows that follow delineate the aggressive and irrational decisions made for the firm.

At planned (210) units, what was the true value of the Tri Star program?

Lockheed Martin's estimated break-even sales point was between 195 to 205 aircraft.  The company did not succeed to perform basic net present value calculations that would have presented a proposal that objectively took in costs and cash flows into consideration.  This negatively impacted the company, as the basic net present values could have delineated a better timeline for the firm to measure its progress into positive cash flow.  Thus, there was a lack of real value that was added into the firm that could have potentially been "too big to fail."

How I calculated the NPV was by analyzing the break-even sales figures. 

Source	Estimated Production Units	Estimated Cost Per Unit (in millions)	NPV (10%)
Lockheed	210	$14	($584)
Lockheed	275	$12.50	($311)
Industry Analysis	300	$12.50	($274)
Actual Break-even	402	$11.75	$47
Lucrative Project Scenario	500	$11	$436

The analysis indicates that the cash flows were approximately $900 million from 1967 to 1971.  As we take a look from 1971 to 1977, Lockheed's expectations to shareholders were to produce 210 Tri Star planes at an average unit production cost of $14 million per aircraft.  This included 35 planes.

The discount rate is also imperative to take into consideration.  At a 10% discount rate, the NPV resulted in a negative $584 million.

At a “break-even” production of roughly 300 units, did Lockheed really break-even in value terms?

The break-even sales point of Lockheed was expected to be 300 units.  This meant that the NPV was not sufficient to handle the expenses of $274 million.  Instead, Lockheed reached a break-even sales point that resulted in a profit of $962.5 million.  This sales point covered developmental costs of $960 million.

Planes	Estimated Product Expense
300	$12.5M
333	$12.25M
366	$12M
400	$11.75M
433	$11.5M
466	$11.25M
500	$11M

Reflecting on this analysis, the discount rate for Lockheed was given to us as 10%.  Other figures could have taken place if the firm considered taking on more risk.  If estimated at a discount rate of 15%, the firm would have sold 420 planes, which would cost $11.75 million per each unit.  This is most likely the main reason as to why the firm's stock price dropped 96%, which took place between the years of 1967 to 1974.  For a firm as big as Lockheed Martin, it was severely difficult to rebound quickly after such as dramatic decrease in the stock price.

At what sales volume did the Tri Star program reach true economic (as opposed to accounting) break-even?

Lockheed's stock price dropped from $64 to $11 per share.  Lockheed's actions caused the Tri Star program to be an extremely risk-seeking program.  If another team of financial analysts were on board to make these critical  investment decisions, perhaps the entire project would have not even been experimented, which would allow Lockheed to concentrate its capital into a more lucrative acquisition, project, or investment.

		Break Even
Discount Rate	# of Units	$11.75 M	$12 M
10%	402	$47	(9)
15%	420	$0	(142)
20%	636	$3	(47)

The Capital Budgeting Conclusion of Lockheed Martin Capital: Improper and Irrational Decision-Making Due to Substantial Amounts of Capital

 (Send me a quick message or email for permission to view my  COMPLETED EXCEL DOC!!  This includes the complete NPV break-down analysis for the first 10 years of Lockheed Martin's cash flows)

           

As we analyze the cash flows that are listed, it quickly becomes evident when searching for the NPV, we notice the avoidance or delusion that the analysts on the Tri Star group have been avoiding.  The analysts did not expect to have a track record during the first five years of entering cash flows, that there would be a consecutive five-year expense of $200 million.  In addition, management should have also noticed that there could also be other negative financial situations that could easily emerge that could compound the financial burden imposed on the overly-aggressive firm that was not even “first to market its products”.  As a result, the firm’s overall outlook is reflected as a very risk-seeking firm.  On another note, it is imperative to point out that there was tremendous positive cash flow in Year 10, but this type of financial behavior and reward is rare that most analysts would not dare take the risks, especially after the 2008 financial crisis.