Accounting for Frequent Fliers 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 Accounting for Frequent Fliers case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Accounting for Frequent Fliers case study is a Harvard Business School (HBR) case study written by William J. Bruns Jr., Susan S. Harmeling. The Accounting for Frequent Fliers (referred as “Frequent Flier” from here on) case study provides evaluation & decision scenario in field of Finance & Accounting. It also touches upon business topics such as - Value proposition, Business law, Costs.

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 Accounting for Frequent Fliers Case Study

Airline frequent flier programs offer members the opportunity to earn free flights by accumulating mileage. Accounting and reporting the obligations of airlines and the cost of frequent flier programs raises difficult measurement issues. In 1991, the U.S. Securities and Exchange Commission began to require airlines to disclose the number of free flights program members took. The case allows estimates of the cost and obligations of the United Air Lines program.

Case Authors : William J. Bruns Jr., Susan S. Harmeling

Topic : Finance & Accounting

Related Areas : Business law, Costs

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Calculating Net Present Value (NPV) at 6% for Accounting for Frequent Fliers Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10013868)	-10013868	-	-
Year 1	3465560	-6548308	3465560	0.9434	3269396
Year 2	3960256	-2588052	7425816	0.89	3524614
Year 3	3970345	1382293	11396161	0.8396	3333578
Year 4	3251892	4634185	14648053	0.7921	2575803
TOTAL			14648053		12703391

The Net Present Value at 6% discount rate is 2689523

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. Magnitude of both incoming and outgoing cash flows – Projects can be capital intensive, time intensive, or both. Frequent Flier 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 Frequent Flier 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 Accounting for Frequent Fliers

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 Frequent Flier 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 Frequent Flier 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	(10013868)	-10013868	-	-
Year 1	3465560	-6548308	3465560	0.8696	3013530
Year 2	3960256	-2588052	7425816	0.7561	2994522
Year 3	3970345	1382293	11396161	0.6575	2610566
Year 4	3251892	4634185	14648053	0.5718	1859280
TOTAL					10477899

The Net NPV after 4 years is 464031

(10477899 - 10013868 )

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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	(10013868)	-10013868	-	-
Year 1	3465560	-6548308	3465560	0.8333	2887967
Year 2	3960256	-2588052	7425816	0.6944	2750178
Year 3	3970345	1382293	11396161	0.5787	2297653
Year 4	3251892	4634185	14648053	0.4823	1568235
TOTAL					9504033

The Net NPV after 4 years is -509835

At 20% discount rate the NPV is negative (9504033 - 10013868 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Frequent Flier 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 Frequent Flier has a NPV value higher than Zero then finance managers at Frequent Flier 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 Frequent Flier, then the stock price of the Frequent Flier 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 Frequent Flier 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 can impact the cash flow of the project.

Understanding of risks involved in 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.

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 Accounting for Frequent Fliers

References & Further Readings

William J. Bruns Jr., Susan S. Harmeling (2018), "Accounting for Frequent Fliers Harvard Business Review Case Study. Published by HBR Publications.