Dealing with low-cost competition in the airline industry (A): The case of Lufthansa Net Present Value (NPV) / MBA Resources

Introduction to Net Present Value (NPV) - What is Net Present Value (NPV) ? How it impacts financial decisions regarding project management?

NPV solution for Dealing with low-cost competition in the airline industry (A): The case of Lufthansa case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Dealing with low-cost competition in the airline industry (A): The case of Lufthansa case study is a Harvard Business School (HBR) case study written by Urs Mueller, Francis Bidault. The Dealing with low-cost competition in the airline industry (A): The case of Lufthansa (referred as “Germanwings 2002” from here on) case study provides evaluation & decision scenario in field of Strategy & Execution. It also touches upon business topics such as - Value proposition, Disruptive innovation.

The net present value (NPV) of an investment proposal is the present value of the proposal’s net cash flows less the proposal’s initial cash outflow. If a project’s NPV is greater than or equal to zero, the project should be accepted.

NPV = Present Value of Future Cash Flows LESS Project’s Initial Investment

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Case Description of Dealing with low-cost competition in the airline industry (A): The case of Lufthansa Case Study

In 2002 the management team of Deutsche Lufthansa AG was considering the upcoming threat from low-cost airlines in the context of an increasingly complex and competitive strategic environment. Finally the decision was taken to respond to the innovation by opening an own low-cost carrier, Germanwings in late 2002. But over time the business model of Germanwings was modified repeatedly. The case series covers * Lufthansa's considerations regarding various options to respond to the competitive challenges brought up by the emerging low-cost airlines such as easyJet or Ryanair in 2002 (Case A), * the foundation of Germanwings in late 2002 and some early successes until 2005 (Case B), and * some more recent changes in the Germanwings business model in the following five years until end of 2010 (Case C).

Case Authors : Urs Mueller, Francis Bidault

Topic : Strategy & Execution

Related Areas : Disruptive innovation

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Calculating Net Present Value (NPV) at 6% for Dealing with low-cost competition in the airline industry (A): The case of Lufthansa Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10009018)	-10009018	-	-
Year 1	3457066	-6551952	3457066	0.9434	3261383
Year 2	3954446	-2597506	7411512	0.89	3519443
Year 3	3938547	1341041	11350059	0.8396	3306880
Year 4	3247468	4588509	14597527	0.7921	2572299
TOTAL			14597527		12660005

The Net Present Value at 6% discount rate is 2650987

In isolation the NPV number doesn't mean much but put in right context then it is one of the best method to evaluate project returns. In this article we will cover -

Different methods of capital budgeting

What is NPV & Formula of NPV,
How it is calculated,
How to use NPV number for project evaluation, and
Scenario Planning given risks and management priorities.

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Capital Budgeting Approaches

Methods of Capital Budgeting

There are four types of capital budgeting techniques that are widely used in the corporate world –

1. Net Present Value
2. Internal Rate of Return
3. Payback Period
4. Profitability Index

Apart from the Payback period method which is an additive method, rest of the methods are based on Discounted Cash Flow technique. Even though cash flow can be calculated based on the nature of the project, for the simplicity of the article we are assuming that all the expected cash flows are realized at the end of the year.

Discounted Cash Flow approaches provide a more objective basis for evaluating and selecting investment projects. They take into consideration both –

1. Magnitude of both incoming and outgoing cash flows – Projects can be capital intensive, time intensive, or both. Germanwings 2002 shareholders have preference for diversified projects investment rather than prospective high income from a single capital intensive project.
2. Timing of the expected cash flows – stockholders of Germanwings 2002 have higher preference for cash returns over 4-5 years rather than 10-15 years given the nature of the volatility in the industry.

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Formula and Steps to Calculate Net Present Value (NPV) of Dealing with low-cost competition in the airline industry (A): The case of Lufthansa

NPV = Net Cash In Flowt1 / (1+r)t1 + Net Cash In Flowt2 / (1+r)t2 + … Net Cash In Flowtn / (1+r)tn
Less Net Cash Out Flowt0 / (1+r)t0

Where t = time period, in this case year 1, year 2 and so on.
r = discount rate or return that could be earned using other safe proposition such as fixed deposit or treasury bond rate. Net Cash In Flow – What the firm will get each year.
Net Cash Out Flow – What the firm needs to invest initially in the project.

Step 1 – Understand the nature of the project and calculate cash flow for each year.
Step 2 – Discount those cash flow based on the discount rate.
Step 3 – Add all the discounted cash flow.
Step 4 – Selection of the project

Why Strategy & Execution Managers need to know Financial Tools such as Net Present Value (NPV)?

In our daily workplace we often come across people and colleagues who are just focused on their core competency and targets they have to deliver. For example marketing managers at Germanwings 2002 often design programs whose objective is to drive brand awareness and customer reach. But how that 30 point increase in brand awareness or 10 point increase in customer touch points will result into shareholders’ value is not specified.

To overcome such scenarios managers at Germanwings 2002 needs to not only know the financial aspect of project management but also needs to have tools to integrate them into part of the project development and monitoring plan.

Calculating Net Present Value (NPV) at 15%

After working through various assumptions we reached a conclusion that risk is far higher than 6%. In a reasonably stable industry with weak competition - 15% discount rate can be a good benchmark.

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 15 %	Discounted Cash Flows
Year 0	(10009018)	-10009018	-	-
Year 1	3457066	-6551952	3457066	0.8696	3006144
Year 2	3954446	-2597506	7411512	0.7561	2990129
Year 3	3938547	1341041	11350059	0.6575	2589659
Year 4	3247468	4588509	14597527	0.5718	1856750
TOTAL					10442683

The Net NPV after 4 years is 433665

(10442683 - 10009018 )

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Calculating Net Present Value (NPV) at 20%

If the risk component is high in the industry then we should go for a higher hurdle rate / discount rate of 20%.

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 20 %	Discounted Cash Flows
Year 0	(10009018)	-10009018	-	-
Year 1	3457066	-6551952	3457066	0.8333	2880888
Year 2	3954446	-2597506	7411512	0.6944	2746143
Year 3	3938547	1341041	11350059	0.5787	2279252
Year 4	3247468	4588509	14597527	0.4823	1566101
TOTAL					9472385

The Net NPV after 4 years is -536633

At 20% discount rate the NPV is negative (9472385 - 10009018 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Germanwings 2002 to discount cash flow at lower discount rates such as 15%.

Acceptance Criteria of a Project based on NPV

Simplest Approach – If the investment project of Germanwings 2002 has a NPV value higher than Zero then finance managers at Germanwings 2002 can ACCEPT the project, otherwise they can reject the project. This means that project will deliver higher returns over the period of time than any alternate investment strategy.

In theory if the required rate of return or discount rate is chosen correctly by finance managers at Germanwings 2002, then the stock price of the Germanwings 2002 should change by same amount of the NPV. In real world we know that share price also reflects various other factors that can be related to both macro and micro environment.

In the same vein – accepting the project with zero NPV should result in stagnant share price. Finance managers use discount rates as a measure of risk components in the project execution process.

Sensitivity Analysis

Project selection is often a far more complex decision than just choosing it based on the NPV number. Finance managers at Germanwings 2002 should conduct a sensitivity analysis to better understand not only the inherent risk of the projects but also how those risks can be either factored in or mitigated during the project execution. Sensitivity analysis helps in –

What are the key aspects of the projects that need to be monitored, refined, and retuned for continuous delivery of projected cash flows.

What will be a multi year spillover effect of various taxation regulations.

What can impact the cash flow of the project.

What are the uncertainties surrounding the project Initial Cash Outlay (ICO’s). ICO’s often have several different components such as land, machinery, building, and other equipment.

Understanding of risks involved in the project.

Some of the assumptions while using the Discounted Cash Flow Methods –

Projects are assumed to be Mutually Exclusive – This is seldom the came in modern day giant organizations where projects are often inter-related and rejecting a project solely based on NPV can result in sunk cost from a related project.

Independent projects have independent cash flows – As explained in the marketing project – though the project may look independent but in reality it is not as the brand awareness project can be closely associated with the spending on sales promotions and product specific advertising.

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Negotiation Strategy of Dealing with low-cost competition in the airline industry (A): The case of Lufthansa

References & Further Readings

Urs Mueller, Francis Bidault (2018), "Dealing with low-cost competition in the airline industry (A): The case of Lufthansa Harvard Business Review Case Study. Published by HBR Publications.