Airlines and Antitrust: Scrutinizing the American Airlines-US Airways Merger 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 Airlines and Antitrust: Scrutinizing the American Airlines-US Airways Merger case study

At Oak Spring University, we provide corporate level professional Net Present Value (NPV) case study solution. Airlines and Antitrust: Scrutinizing the American Airlines-US Airways Merger case study is a Harvard Business School (HBR) case study written by Jose Gomez-Ibanez, Anjani Datla. The Airlines and Antitrust: Scrutinizing the American Airlines-US Airways Merger (referred as “Airlines Airline” from here on) case study provides evaluation & decision scenario in field of Global Business. It also touches upon business topics such as - Value proposition, Financial management, Government, Market research, Mergers & acquisitions.

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 Airlines and Antitrust: Scrutinizing the American Airlines-US Airways Merger Case Study

In August 2013, the Antitrust Division of the Department of Justice (DOJ) shocked many in the airline industry by filing a lawsuit to block the merger of American Airlines and US Airways on the grounds that the merger would reduce competition. The two airlines had announced their intention to merge in February, making way for the creation of the largest airline in the world. The new airline would carry roughly 200 million passengers a year, employ more than 100,000 workers, and have total revenues of nearly $40 billion. The American Airlines-US Airways merger was only the latest, albeit the largest, in a recent spate of airline mergers. During the first decade of the twenty-first century, the airline industry had been plagued by economic recession, high fuel prices, record losses and bankruptcies. Starting in the mid-2000s, airline executives responded with an aggressive program of consolidation. Mega deals, such as the merger of Delta and Northwest (in 2008), United and Continental (2010), and, Southwest and AirTran (2011), had dramatically reshaped the industry. If approved by federal authorities, the merger between American Airlines and US Airways would leave four major airlines (American, Delta, United and Southwest) in control of 80 percent of the domestic market, down from nine major carriers in 2005. Part A of this case summarizes the historical ups and downs of the volatile US airline industry, the concerns raised by the DOJ and the responses of American Airlines and US Airways, and asks students to weigh the evidence and determine if the advantages of combining the two airlines outweigh the potential harm to consumers. The case sequel describes how the DOJ eventually settled the lawsuit with the airlines, after American agreed to divest slots and gates at several airports in November 2013.

Case Authors : Jose Gomez-Ibanez, Anjani Datla

Topic : Global Business

Related Areas : Financial management, Government, Market research, Mergers & acquisitions

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Calculating Net Present Value (NPV) at 6% for Airlines and Antitrust: Scrutinizing the American Airlines-US Airways Merger Case Study

Years	Cash Flow	Net Cash Flow	Cumulative     Cash Flow	Discount Rate @ 6 %	Discounted Cash Flows
Year 0	(10024272)	-10024272	-	-
Year 1	3444472	-6579800	3444472	0.9434	3249502
Year 2	3965286	-2614514	7409758	0.89	3529090
Year 3	3940752	1326238	11350510	0.8396	3308731
Year 4	3238539	4564777	14589049	0.7921	2565226
TOTAL			14589049		12652550

The Net Present Value at 6% discount rate is 2628278

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. Payback Period
2. Net Present Value
3. Internal Rate of Return
4. Profitability Index

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. Airlines Airline 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 Airlines Airline 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 Airlines and Antitrust: Scrutinizing the American Airlines-US Airways Merger

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 Airlines Airline 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 Airlines Airline 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	(10024272)	-10024272	-	-
Year 1	3444472	-6579800	3444472	0.8696	2995193
Year 2	3965286	-2614514	7409758	0.7561	2998326
Year 3	3940752	1326238	11350510	0.6575	2591108
Year 4	3238539	4564777	14589049	0.5718	1851645
TOTAL					10436273

The Net NPV after 4 years is 412001

(10436273 - 10024272 )

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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	(10024272)	-10024272	-	-
Year 1	3444472	-6579800	3444472	0.8333	2870393
Year 2	3965286	-2614514	7409758	0.6944	2753671
Year 3	3940752	1326238	11350510	0.5787	2280528
Year 4	3238539	4564777	14589049	0.4823	1561795
TOTAL					9466387

The Net NPV after 4 years is -557885

At 20% discount rate the NPV is negative (9466387 - 10024272 ) so ideally we can't select the project if macro and micro factors don't allow financial managers of Airlines Airline 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 Airlines Airline has a NPV value higher than Zero then finance managers at Airlines Airline 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 Airlines Airline, then the stock price of the Airlines Airline 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 Airlines Airline 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 –

Understanding of risks involved in 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.

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 will be a multi year spillover effect of various taxation regulations.

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 Airlines and Antitrust: Scrutinizing the American Airlines-US Airways Merger

References & Further Readings

Jose Gomez-Ibanez, Anjani Datla (2018), "Airlines and Antitrust: Scrutinizing the American Airlines-US Airways Merger Harvard Business Review Case Study. Published by HBR Publications.