Low-cost Carriers in India: SpiceJet's Perspective 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 Low-cost Carriers in India: SpiceJet's Perspective case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Low-cost Carriers in India: SpiceJet's Perspective case study is a Harvard Business School (HBR) case study written by Sanjeev Prashar, Adeshwar Raja Balaji Pras, V.S. Parasaran, Vijay Kumar Venna. The Low-cost Carriers in India: SpiceJet's Perspective (referred as “Lccs Spicejet” from here on) case study provides evaluation & decision scenario in field of Strategy & Execution. It also touches upon business topics such as - Value proposition, .

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 Low-cost Carriers in India: SpiceJet's Perspective Case Study

This case discusses the emergence of low-cost carriers (LCCs) in India in relation to the growth of the Indian aviation industry and the subsequent fall of the LCCs into financial loss. The LCCs became important for value-adding and cost-cutting alternatives in corporate business travel. Before the 2008 global economic crisis, domestic air traffic LCCs recorded a compound annual passenger growth rate of 18 per cent. Among the many low-cost airlines in India, SpiceJet had been one of the most popular, with the lowest airfares and highest customer value. Though SpiceJet had a net profit of INR 1.01 billion (US$20.2 million) in fiscal year 2010-2011, the results following the financial year indicated that the company had also joined the ranks of loss-making airlines in India. A host of issues - such as rising debt, increasing cost to revenue ratios, growing management challenges, complicated flight operations, and rising oil prices - were threatening the survival of airline companies, especially LCCs. SpiceJet was no exception.

Case Authors : Sanjeev Prashar, Adeshwar Raja Balaji Pras, V.S. Parasaran, Vijay Kumar Venna

Topic : Strategy & Execution

Related Areas :

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Calculating Net Present Value (NPV) at 6% for Low-cost Carriers in India: SpiceJet's Perspective Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10017862)	-10017862	-	-
Year 1	3451243	-6566619	3451243	0.9434	3255890
Year 2	3981120	-2585499	7432363	0.89	3543183
Year 3	3946750	1361251	11379113	0.8396	3313767
Year 4	3231157	4592408	14610270	0.7921	2559379
TOTAL			14610270		12672219

The Net Present Value at 6% discount rate is 2654357

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. Payback Period
3. Internal Rate of Return
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. Lccs Spicejet 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 Lccs Spicejet 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 Low-cost Carriers in India: SpiceJet's Perspective

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 Lccs Spicejet 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 Lccs Spicejet 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	(10017862)	-10017862	-	-
Year 1	3451243	-6566619	3451243	0.8696	3001081
Year 2	3981120	-2585499	7432363	0.7561	3010299
Year 3	3946750	1361251	11379113	0.6575	2595052
Year 4	3231157	4592408	14610270	0.5718	1847425
TOTAL					10453856

The Net NPV after 4 years is 435994

(10453856 - 10017862 )

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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	(10017862)	-10017862	-	-
Year 1	3451243	-6566619	3451243	0.8333	2876036
Year 2	3981120	-2585499	7432363	0.6944	2764667
Year 3	3946750	1361251	11379113	0.5787	2283999
Year 4	3231157	4592408	14610270	0.4823	1558235
TOTAL					9482937

The Net NPV after 4 years is -534925

At 20% discount rate the NPV is negative (9482937 - 10017862 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Lccs Spicejet 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 Lccs Spicejet has a NPV value higher than Zero then finance managers at Lccs Spicejet 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 Lccs Spicejet, then the stock price of the Lccs Spicejet 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 Lccs Spicejet 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.

Understanding of risks involved in 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.

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

What can impact the cash flow of 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 Low-cost Carriers in India: SpiceJet's Perspective

References & Further Readings

Sanjeev Prashar, Adeshwar Raja Balaji Pras, V.S. Parasaran, Vijay Kumar Venna (2018), "Low-cost Carriers in India: SpiceJet's Perspective Harvard Business Review Case Study. Published by HBR Publications.