# Lockheed Tri Star Case Studies

Summary

Rainbow Products is considering purchasing a paint-mixing machine to reduce labor costs. The machine costs \$35,000 and is expected to last for 15 years, resulting in additional cash flows of \$5,000 per year. The cost of capital for such an investment is 12%. The payback, net present value (NPV), and internal rate of return (IRR) were calculated to determine if Rainbow should purchase the machine. The results show that the machine has a payback period of 7 years, an NPV of \$11,712, and an IRR of 16.16%, indicating that Rainbow should purchase the machine. In scenario B, Rainbow can get a service contract for an additional \$500 per year to keep the machine in new condition forever. The machine would produce cash flows of \$4,500 per year in perpetuity, net of the cost of the service contract. It was analyzed whether Rainbow should purchase the machine with the service contract or not. In this case, the engineers have suggested reinvesting 20% of the annual cost savings back into new machine parts, which would increase the cost savings at a 4% annual rate. The formula for the present value of an initial end-of-year perpetuity payout was used to analyze the reinvestment option. The results show that Rainbow should choose the reinvestment option as it has a higher NPV compared to the service contract option.

Table of Content

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] 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. [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?

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?

HINT: The formula for the present value (V) of an initial end-of-year perpetuity payout of \$C (growing at g%) per period, with a discount rate of k%, is: V= C k? g Professor Michael E. Edleson prepared this case as the basis for class discussion rather than to illustrate either effective or ineffective handling of an administrative situation. Portions of this case are based on an earlier case, “Interest Rate Exercises,” HBS No. 289-050 by Professor Richard Ruback.