Southwest Airlines--1993 (A), Portuguese Version 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 Southwest Airlines--1993 (A), Portuguese Version case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Southwest Airlines--1993 (A), Portuguese Version case study is a Harvard Business School (HBR) case study written by James L. Heskett, Roger Hallowell. The Southwest Airlines--1993 (A), Portuguese Version (referred as “Southwest Airlines” from here on) case study provides evaluation & decision scenario in field of Technology & Operations. It also touches upon business topics such as - Value proposition, Growth strategy, Organizational culture, Supply chain.

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 Southwest Airlines--1993 (A), Portuguese Version Case Study

Southwest Airlines, the only major U.S. airline to be profitable in 1992, makes a decision as to which of two new cities to open, or to add a new long-haul route. Provides windows into Southwest's strategy, operations, marketing, and culture.

Case Authors : James L. Heskett, Roger Hallowell

Topic : Technology & Operations

Related Areas : Growth strategy, Organizational culture, Supply chain

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Calculating Net Present Value (NPV) at 6% for Southwest Airlines--1993 (A), Portuguese Version Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10001059)	-10001059	-	-
Year 1	3444516	-6556543	3444516	0.9434	3249543
Year 2	3971495	-2585048	7416011	0.89	3534616
Year 3	3964564	1379516	11380575	0.8396	3328724
Year 4	3247446	4626962	14628021	0.7921	2572281
TOTAL			14628021		12685166

The Net Present Value at 6% discount rate is 2684107

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. Profitability Index
3. Internal Rate of Return
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 Southwest Airlines 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. Southwest Airlines 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 Southwest Airlines--1993 (A), Portuguese Version

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 Technology & Operations 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 Southwest Airlines 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 Southwest Airlines 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	(10001059)	-10001059	-	-
Year 1	3444516	-6556543	3444516	0.8696	2995231
Year 2	3971495	-2585048	7416011	0.7561	3003021
Year 3	3964564	1379516	11380575	0.6575	2606765
Year 4	3247446	4626962	14628021	0.5718	1856738
TOTAL					10461755

The Net NPV after 4 years is 460696

(10461755 - 10001059 )

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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	(10001059)	-10001059	-	-
Year 1	3444516	-6556543	3444516	0.8333	2870430
Year 2	3971495	-2585048	7416011	0.6944	2757983
Year 3	3964564	1379516	11380575	0.5787	2294308
Year 4	3247446	4626962	14628021	0.4823	1566091
TOTAL					9488811

The Net NPV after 4 years is -512248

At 20% discount rate the NPV is negative (9488811 - 10001059 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Southwest Airlines 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 Southwest Airlines has a NPV value higher than Zero then finance managers at Southwest Airlines 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 Southwest Airlines, then the stock price of the Southwest Airlines 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 Southwest Airlines 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 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 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.

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 Southwest Airlines--1993 (A), Portuguese Version

References & Further Readings

James L. Heskett, Roger Hallowell (2018), "Southwest Airlines--1993 (A), Portuguese Version Harvard Business Review Case Study. Published by HBR Publications.