VivaColombia: The Challenge of Growing a Low-Cost Airline in Latin America 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 VivaColombia: The Challenge of Growing a Low-Cost Airline in Latin America case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. VivaColombia: The Challenge of Growing a Low-Cost Airline in Latin America case study is a Harvard Business School (HBR) case study written by Elkin Rave, Juan Franco. The VivaColombia: The Challenge of Growing a Low-Cost Airline in Latin America (referred as “Vivacolombia Domestic” from here on) case study provides evaluation & decision scenario in field of Global Business. It also touches upon business topics such as - Value proposition, Decision making, 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 VivaColombia: The Challenge of Growing a Low-Cost Airline in Latin America Case Study

The case describes the emergence and business model of VivaColombia, a low-cost Colombian airline. The airline was established in 2008, although it did not begin operations until May 2012. Since its inception, VivaColombia has grown within both the domestic and international markets. It provides passenger transportation services to major and intermediate cities in Colombia and to major cities in international destinations. In 2015, VivaColombia had nine Airbus A320 aircraft serving 21 routes in Colombia and six international routes in North, Central, and South America. It had over 500 employees. In 2015, it carried over 2.9 million passengers on domestic and international flights, with sales of $US119.2 million and profits of more than $US971,000. Although VivaColombia's board of directors was satisfied with the results achieved to date, they disagreed about how to proceed. Some board members believed that VivaColombia should consolidate its domestic operations. They were concerned about the large number of customer service complaints that had accompanied its rapid growth. In addition, two low-cost international carriers were planning to enter the Colombian market, which the board feared would jeopardize VivaColombia's position in the domestic market. Other board members thought VivaColombia should take advantage of the opportunity to expand into Brazil, a major Latin American market, presented by Aerocivil, Colombia's civil aviation authority, which had authorized VivaColombia to operate the Bogota, Colombia-Sao Paulo, Brazil route. Students must decide whether the company should expand into Brazil or consolidate operations in the domestic market.

Case Authors : Elkin Rave, Juan Franco

Topic : Global Business

Related Areas : Decision making, Supply chain

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Calculating Net Present Value (NPV) at 6% for VivaColombia: The Challenge of Growing a Low-Cost Airline in Latin America Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10016425)	-10016425	-	-
Year 1	3468470	-6547955	3468470	0.9434	3272142
Year 2	3981131	-2566824	7449601	0.89	3543192
Year 3	3966318	1399494	11415919	0.8396	3330197
Year 4	3228656	4628150	14644575	0.7921	2557398
TOTAL			14644575		12702929

The Net Present Value at 6% discount rate is 2686504

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. Internal Rate of Return
2. Profitability Index
3. Net Present Value
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. Vivacolombia Domestic 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 Vivacolombia Domestic 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 VivaColombia: The Challenge of Growing a Low-Cost Airline in Latin America

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 Global Business 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 Vivacolombia Domestic 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 Vivacolombia Domestic 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	(10016425)	-10016425	-	-
Year 1	3468470	-6547955	3468470	0.8696	3016061
Year 2	3981131	-2566824	7449601	0.7561	3010307
Year 3	3966318	1399494	11415919	0.6575	2607918
Year 4	3228656	4628150	14644575	0.5718	1845995
TOTAL					10480281

The Net NPV after 4 years is 463856

(10480281 - 10016425 )

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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	(10016425)	-10016425	-	-
Year 1	3468470	-6547955	3468470	0.8333	2890392
Year 2	3981131	-2566824	7449601	0.6944	2764674
Year 3	3966318	1399494	11415919	0.5787	2295323
Year 4	3228656	4628150	14644575	0.4823	1557029
TOTAL					9507418

The Net NPV after 4 years is -509007

At 20% discount rate the NPV is negative (9507418 - 10016425 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Vivacolombia Domestic 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 Vivacolombia Domestic has a NPV value higher than Zero then finance managers at Vivacolombia Domestic 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 Vivacolombia Domestic, then the stock price of the Vivacolombia Domestic 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 Vivacolombia Domestic 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 will be a multi year spillover effect of various taxation regulations.

Understanding of risks involved in the project.

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.

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 VivaColombia: The Challenge of Growing a Low-Cost Airline in Latin America

References & Further Readings

Elkin Rave, Juan Franco (2018), "VivaColombia: The Challenge of Growing a Low-Cost Airline in Latin America Harvard Business Review Case Study. Published by HBR Publications.