Guardian Air: Planning a Decision Process for Helicopter Engines 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 Guardian Air: Planning a Decision Process for Helicopter Engines case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Guardian Air: Planning a Decision Process for Helicopter Engines case study is a Harvard Business School (HBR) case study written by Timothy S. Clark. The Guardian Air: Planning a Decision Process for Helicopter Engines (referred as “Decision Engines” from here on) case study provides evaluation & decision scenario in field of Technology & Operations. It also touches upon business topics such as - Value proposition, Health, Managing organizations, Operations management.

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 Guardian Air: Planning a Decision Process for Helicopter Engines Case Study

Facing operational constraints due to helicopter engines with sub-optimal power during hot weather at high altitudes, the program manager for an air-ambulance operator must plan for a decision process to consider upgrading the engines of any, many, or all of his program's seven helicopters. Long before putting the decision before his parent company's executives or board of directors, he needs to develop lists of relevant quantitative variables and what's known about them, qualitative factors and considerations, and stakeholders and their interests, all in order to methodically structure a process to better advance conversations with his colleagues toward a more efficient and effective outcome. Presented as a qualitative task of decision preparation, this case focuses on the early steps of rational decision-making processes, such as "define the problem" and "identify the criteria," without going further toward a decision recommendation. Intended for the first weeks of managerial-decision making courses, the case distinguishes the value of comprehensively considering the set-up of complex decision processes as pre-requisite to subsequent steps. Especially for students who see "making a decision" as actions taken with calculators and spreadsheets, this case is intended to demonstrate the value of prior steps in decision processes that include complexity, uncertainty, and colleagues who must be "on the same page" along the way. Further, the vivid overlap of the healthcare industry with aviation operations is intended to heighten student interest, with contextual information on how the medical-transport industry operates.

Case Authors : Timothy S. Clark

Topic : Technology & Operations

Related Areas : Health, Managing organizations, Operations management

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Calculating Net Present Value (NPV) at 6% for Guardian Air: Planning a Decision Process for Helicopter Engines Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10011409)	-10011409	-	-
Year 1	3465994	-6545415	3465994	0.9434	3269806
Year 2	3965514	-2579901	7431508	0.89	3529293
Year 3	3973557	1393656	11405065	0.8396	3336275
Year 4	3234239	4627895	14639304	0.7921	2561820
TOTAL			14639304		12697194

The Net Present Value at 6% discount rate is 2685785

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. Magnitude of both incoming and outgoing cash flows – Projects can be capital intensive, time intensive, or both. Decision Engines 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 Decision Engines 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 Guardian Air: Planning a Decision Process for Helicopter Engines

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 Decision Engines 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 Decision Engines 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	(10011409)	-10011409	-	-
Year 1	3465994	-6545415	3465994	0.8696	3013908
Year 2	3965514	-2579901	7431508	0.7561	2998498
Year 3	3973557	1393656	11405065	0.6575	2612678
Year 4	3234239	4627895	14639304	0.5718	1849187
TOTAL					10474271

The Net NPV after 4 years is 462862

(10474271 - 10011409 )

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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	(10011409)	-10011409	-	-
Year 1	3465994	-6545415	3465994	0.8333	2888328
Year 2	3965514	-2579901	7431508	0.6944	2753829
Year 3	3973557	1393656	11405065	0.5787	2299512
Year 4	3234239	4627895	14639304	0.4823	1559722
TOTAL					9501391

The Net NPV after 4 years is -510018

At 20% discount rate the NPV is negative (9501391 - 10011409 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Decision Engines 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 Decision Engines has a NPV value higher than Zero then finance managers at Decision Engines 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 Decision Engines, then the stock price of the Decision Engines 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 Decision Engines 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 will be a multi year spillover effect of various taxation regulations.

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

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 Guardian Air: Planning a Decision Process for Helicopter Engines

References & Further Readings

Timothy S. Clark (2018), "Guardian Air: Planning a Decision Process for Helicopter Engines Harvard Business Review Case Study. Published by HBR Publications.