RegionFly: Cutting Costs in the Airline Industry 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 RegionFly: Cutting Costs in the Airline Industry case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. RegionFly: Cutting Costs in the Airline Industry case study is a Harvard Business School (HBR) case study written by Susanna Gallani, Eva Labro. The RegionFly: Cutting Costs in the Airline Industry (referred as “Regionfly Criterion” from here on) case study provides evaluation & decision scenario in field of Finance & Accounting. 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 RegionFly: Cutting Costs in the Airline Industry Case Study

RegionFly is a small, private airline specializing in ultra-premium services. Founded shortly after the "Golden Age of airline travel," RegionFly's financial performance had been strong for several decades. More recently, however, the results have taken a downward trend, due in part to the impact of the Great Recession on the entire airline industry. Not only were premium service providers affected more significantly, but the recent wave of mergers and acquisitions involving large airlines also leveraged new economies of scale, thereby reducing costs and increasing the competitive pressure on air travel prices. As a result of the deterioration in their financial performance, RegionFly was recently acquired by a larger provider, and several top managers were replaced. The new management team, supported by an external consulting firm, introduced a series of aggressive cost-cutting measures that resulted in a downsizing of the workforce, and impacted some distinctive features of the services provided by RegionFly that had been historically associated with the success of the company. Additionally, top management introduced a new product profitability criterion to be used in support of strategic decisions related to the composition of the product mix offering. The application of the new criterion lead to the elimination of two of the seven routes included in RegionFly's portfolio. To the surprise of top management, however, the cost-cutting and product-cutting measures did not result in an improvement in the profitability of the company, which, in fact, deteriorated even further. As the profitability of another route falls under the threshold, management is faced with an important decision: should the product profitability criterion be enforced, thus eliminating yet another route from the portfolio? "RegionFly: Cutting Costs in the Airline Industry" provides an introduction to costs allocations, to the evaluation of product profitability, and to the impact of the methodology used to allocate fixed costs on strategic decisions, such as eliminating product lines or firm segments.

Case Authors : Susanna Gallani, Eva Labro

Topic : Finance & Accounting

Related Areas :

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Calculating Net Present Value (NPV) at 6% for RegionFly: Cutting Costs in the Airline Industry Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10026702)	-10026702	-	-
Year 1	3451021	-6575681	3451021	0.9434	3255680
Year 2	3955316	-2620365	7406337	0.89	3520217
Year 3	3941766	1321401	11348103	0.8396	3309583
Year 4	3234667	4556068	14582770	0.7921	2562159
TOTAL			14582770		12647639

The Net Present Value at 6% discount rate is 2620937

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. Profitability Index
4. Payback Period

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

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Formula and Steps to Calculate Net Present Value (NPV) of RegionFly: Cutting Costs in the Airline Industry

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 Finance & Accounting 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 Regionfly Criterion 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 Regionfly Criterion 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	(10026702)	-10026702	-	-
Year 1	3451021	-6575681	3451021	0.8696	3000888
Year 2	3955316	-2620365	7406337	0.7561	2990787
Year 3	3941766	1321401	11348103	0.6575	2591775
Year 4	3234667	4556068	14582770	0.5718	1849431
TOTAL					10432881

The Net NPV after 4 years is 406179

(10432881 - 10026702 )

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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	(10026702)	-10026702	-	-
Year 1	3451021	-6575681	3451021	0.8333	2875851
Year 2	3955316	-2620365	7406337	0.6944	2746747
Year 3	3941766	1321401	11348103	0.5787	2281115
Year 4	3234667	4556068	14582770	0.4823	1559928
TOTAL					9463641

The Net NPV after 4 years is -563061

At 20% discount rate the NPV is negative (9463641 - 10026702 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Regionfly Criterion 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 Regionfly Criterion has a NPV value higher than Zero then finance managers at Regionfly Criterion 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 Regionfly Criterion, then the stock price of the Regionfly Criterion 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 Regionfly Criterion 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 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 can impact the cash flow of the project.

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.

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 RegionFly: Cutting Costs in the Airline Industry

References & Further Readings

Susanna Gallani, Eva Labro (2018), "RegionFly: Cutting Costs in the Airline Industry Harvard Business Review Case Study. Published by HBR Publications.