globalairlines slides

8/10/2019 GlobalAirlines Slides

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The Value of Flexibility at

Global Airlines: Real Options

and EDW and CRM


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Facts In past GA differentiated itself by using technology to improve customer

service But prolonged recession and decrease in business spending affected

the business class spending having a negative impact on the cos.Fortunes

There was also a decrease in overall airline capacity, improvement in

economy and additional cost cutting measures which had a positiveimpact on the cos. Fortunes.

Bud Hall the cos. CIO paged Bergin Director (IT) Finance for a urgentmeeting

Issues

Cost cutting had hurt the qualtiy of service

Customer survey downgrade by three levels + Member BoDsexperience

Time to consider data mart project proposed by Bergin. Thoughve NPV its option value needs to be evaluated as bergin has beenarguing so many times


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Data Warehousing


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Facts DM Consolidation Currently, 12 Oracle Data Marts and 3 IBM data marts were fully

depreciatedSo What? RoI of the Data Mart Consolidation is very less

What about RoI of the analytical CRM?

So thats a embeded growth option

What is the uncertainty with regard to the DM Consolidation project?

72% of IT projects not completed on time, overshoots budget anddoes not yield desired results

So what are the risk variables here?

Cost of Consolidation

Because consolidation must happen from different sources

(oracle + IBM) so compatibility issues etc Reduction in head count

We need to simulate the risk variables


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Facts DM Consolidation-Governance Issues

GA- DM consolidation is exogenous risk

Teradata- Consolidation is endogenous GA-Reduction in head count is endogenous risk

Teradata- Reduction in head count is exogenous risk


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Your Task

Tactical: What is the optimal deployment strategy for the project?

Strategic: Should Global Airlines invest in this project? What is the value of the project with the CRM option?


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Options in a Nut Shell

The range of possible

outcomes can improvedramatically when you have anoption

The options value is just thedifference between the

expected value of the projectwith the option and without

What does the $ value of anoption mean?

It is the money you expect togain since you have the option

NPV

Proba

bility

Passive Management

Active Management


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Real Options Analysis Framework1. Business Discovery:Understand the business, and basic cost and revenue

drivers that the new technology project is expected to impact. Make judgmentsand/or assumptions about how the technology project will impact cost andrevenue drivers to improve business performance.

2. Traditional NPV/ROI Analysis: Perform traditional NPV/ROI analysisdiscussed in the ROI Analysis framework. The implementation costs for projectsare the exercise prices for those real options. The present value (PV) of theexpected incremental free cash flows after the firm has implemented thetechnology project is the underlying asset for the real options analysis.

6. Sensitivity Analysis: Perform sensitivity analysis (Excel tools) toincorporate varying volatilities to generate a range of possible outcomes for realoptions valuation.

3. Identify Embedded Options:Identify which options are embeddedoperating options and strategic growth options.

4. Volatility Determination: Determine the volatility (standard deviation of thelogarithmic annual project returns) of technology project returns.

5. Real Options Valuation: Determine the expanded NPV using binomial

lattice structure method. Calculate the option premium by subtracting thetraditional NPV from the expanded NPV. The option premium represents thevalue of the management flexibility.

Real Options

Analysis


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Project Volatility Determination Using

Monte Carlo Simulations Project volatility (the most important factor that goes into the Black Scholes

formula or binomial model) is the standard deviation of logarithmic annualproject returns.

Statistic Value %tile Value

Minimum -33.04% 5% -7.42%

Maximum 42.87% 10% -2.70%

Mean 11.75% 15% 0.21%

Std Dev 10.96% 20% 2.58%Variance 0.012006374 25% 4.49%

Skewness -0.397301392 30% 6.35%

Kurtosis 2.993064949 35% 8.03%

Median 12.55% 40% 9.62%Mode 8.42% 45% 11.07%

Left X -7.42% 50% 12.55%

Left P 5% 55% 13.87%

Right X 28.13% 60% 15.36%

Right P 95% 65% 16.80%

Summary Statistics


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Global Airlines Case Scenario

6 months 6 months 6 months

Phase I Phase IIPhase III5 data marts

5 data marts5 data marts

Phase IPhase II

5 data marts10 data marts

Phase I

15 data marts


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Decision Outcome

Consolidate?

Keepexisting

system

Consolidate

5 data marts

Failure

Do nothing

Success

Consolidate10 data marts

Failure

Successful EDW

Phase I Phase II

t = 0 t = 16 months 12 months

No additionalconsolidation


Tactical Options Decision Tree (510 Project)


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Consolidate?

Keepexistingsystem


Failure

Do nothing

Success


Failure

Success

Decision Outcome

Phase I Phase II


Failure

Successful EDW

Phase III

t = 0 t = 16 months t = 26 months 6 months

No additional

consolidation




Tactical Options Decision Tree (555 Project)


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Facts Analytical CRM Project

To enable personalize maketing offers and promotions

Create marketing campaigns targeted at 400,000 active GA frequentfliers..

Camapaigns would run quarterly and would aim to up silver wingcustomers to gold wing; gold wing to platinum wing.

Thus Platinum wing customer s would increase by 5% p.a. and gold

wing by 12% Currenlty, Platinum5%

Gold - 10%

Silver - 85%

Estimated cost to contact each customer is $0.5; hardware- $1.5M and

Software $2.5M, Professional Sevices $3 M Existing take rate on offers was 2%, expected to increase this to 5%

15% increase in average quarterly spending


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Traditional NPV Analysis

$-

$2,000

$4,000

$6,000

$8,000

$10,000

$12,000

DMC Project DMC Project + CRM

Thousands

NPV

IRR = 16.7% IRR = 35.6%


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Facts Analytical CRM Project Risk Factors

Increase in Take rate from 2% to 5%

Increase in average quarterly spending by 15%


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Real Options Analysis

P j t V l tilit D t i ti U i M t C l Si l ti


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Project Volatility Determination Using Monte Carlo Simulations

Cost Structure Associated with Implementation of Data Warehouse -- December 31st Abandon Data Marts

Nodes, Software, Disks 6,650,000$Profession Services 4,200,000$

Yearly Total 13,292,985$

Investment Cash Outflow at T=0 = Depreciable Basis

Cash Flow Statement

Old Configuration Year 0 Year 1 Year 2 Year 3

Salary & Benefits 13,300,000$ 13,965,000$ 14,663,250$Training -$ -$ -$

Professional Services (consulting) -$ -$ -$Maintenance/upgrades 860,000$ 860,000$ 860,000$Non-personnel support 11,600,000$ 12,064,000$ 12,546,560$

Total 25,760,000$ 26,889,000$ 28,069,810$times (1-tax rate) 15,971,200$ 16,671,180$ 17,403,282$

less tax rate times depreciation -$ -$ -$

total 15,971,200$ 16,671,180$ 17,403,282$

New Configuration Year 0 Year 1 Year 2 Year 3

Salary & Benefits 13,300,000$ 9,329,096$ 9,795,550$Training -$ 720,000$ 720,000$

Professional Services (consulting) -$Maintenance/upgrades 860,000$ 1,400,000$ 1,400,000$Non-personnel support 11,600,000$ 7,488,000$ 7,787,520$

Total 25,760,000$ 18,937,096$ 19,703,070$times (1-tax rate) 15,971,200$ 11,740,999$ 12,215,904$

less tax rate times depreciation (1,010,267)$ (1,616,427)$ (2,424,640)$

total (13,292,985)$ 14,960,933$ 10,124,572$ 9,791,263$

Incremental Cash Flow (13,292,985)$ 1,010,267$ 6,546,608$ 7,612,019$

Net Present Value (NPV) (2,231,488)

Internal Rate of Return (IRR) 5.6%

PV of Incremental Cash Flow V2 12,610,107$ V1 11,929,742$

NPV without exercising option 38,584,476$

Project Return 5.55%

Mean 5.55%

Std. Deviation 0.00%

18.07%

Total Teradata Solut ion Year 0 Cash Flow -- Depreciable Basis for 5-Year MACRS

Excel solution

walkthrough . . .


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Real Options: Basic Framework

Traditional

NPV of PilotProject

Full EDW

Option Value

Expanded

NPV (ENPV)

Traditional

NPV

Option

Premium

Expanded NPV = Traditional

NPV of a PilotProject

+ Option value of a

Full EDWProject

Option Premium = Expanded NPVTraditional NPV


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DM Expanded NPV Calculation

Real Options Program (Three Stage)Input Parameters (Fill in green and yellow boxes)

Risk-Free Int Rate 2.00%

Required Return 14%

Steps 52

Option Volatility Time to Expire (months)

Project 1 - 5DM ==>> 18.32% 0

Project 2 - 5DM ==>> 16.66% 6

Project 3 - 5DM ==>> 17.57% 12

Time Option # Option Description Option Type PV of incremental

CF

Investment

(Strike Price)

Volatility Time to expire

(in years)0 None Project 1 (5DM) Nested CALL 6,256,600$ 6,355,000$ 18.32% 01 1 Project 2 (5DM) Nested CALL 6,349,157$ 5,940,000$ 16.66% 0.52 2 Project 3 (5DM) Real CALL 6,441,311$ 6,710,000$ 17.57% 1

Total NPV of the Three Stage Program

Traditional Approach

NPV - Project 1 (5 DMs) (98,400)$

NPV - Project 2 (5 DMs) 381,650$

NPV - Project 3 (5 DMs) (233,776)$

Total NPV of the Program (Tradtional NPV) 49,473$

Real Option Approach

Total NPV of the Program (Expanded NPV) 660,753$

Option Premium 611,280$


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Real Options Summary

Single-Project

Strategy

Two-Project

Strategy

Three-Project

StrategyTraditional NPV 987,263$ 908,752$ 49,473$

Option Premium -$ 349,231$ 611,280$

Expanded NPV 1,257,983$ 660,753$


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Tactical Real Options Summary

Single-Project Strategy Two-Project Strategy Three-Project Strategy

NP

V

Option Premium

TraditionalNPV

Expanded

NPV


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Sensitivity Analysis

$-

$500,000

$1,000,000

$1,500,000

$2,000,000

$2,500,000

$3,000,000

$3,500,000

$4,000,000

0.00% 20.00% 40.00% 60.00% 80.00% 100.00%

Volatility

Expand

ed

NPV

Two Stage

Three StageTraditional


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CRM Expanded NPV Calculation

Real Options Program (Two Stage) + CRMInput Parameters (Fill in green and yellow boxes)

Risk-Free Int Rate 2.00%

Required Return 14%

Steps 52

Option Volatility Time to Expire (months)

Project 1 - 5DM ==>> 18.32% 0.0000001

Project 2 - 10DM ==>> 18.07% 6

Project 3 - CRM ==>> 45.29% 18

Time Option # Option Description Option Type PV of incremental Investment Volatility Time to expire

0 None Project 1 (5DM) Nested CALL 6,256,600$ 6,355,000$ 18.32% 0

1 1 Project 2 (10 DM) Nested CALL 11,929,742$ 10,850,000$ 18.07% 0.5

2 2 Project 3 (CRM) Real CALL 18,822,012$ 7,000,000$ 45.29% 1.5

Total NPV of the Two Stage Program + CRM

Traditional Approach

NPV - Project 1 (5 DMs) (98,400)$

NPV - Project 2 (10 DMs) 1,007,153$

NPV - Project 3 (CRM) 9,594,392$

Total NPV of the Program (Tradtional NPV) 10,503,144$

Real Option ApproachTotal NPV of the Program (Expanded NPV) 12,952,179$

Option Premium 2,449,035$


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Real Options Summary + CRM

Two-Project

Strategy + CRM

DM Traditional $ 908,752CRM Traditional NPV 9,594,392$

Option Premium 2,449,035$Expanded NPV 12,952,179$

R l O ti G hi l S


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Real Options Graphical Summary

$-

$2,000

$4,000

$6,000

$8,000

$10,000

$12,000

$14,000

Two-Project Strategy + CRM

Th

ousands

NP

V

ExpandedNPV

Option Premium

DM Traditional NPV

CRM Traditional

NPV


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DMC and CRM with Real Options

$-

$2,000

$4,000

$6,000

$8,000

$10,000

$12,000

$14,000

DMC Project DMC Project + CRM

Thousands

NPV Option Premium

Traditional NPV


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Real Options Case Takeaways

The classical NPV of the CRM project with the data mart consolidation (DMC) is verylarge compared to just the classical NPV of the DMC This suggests that the full EDW and CRM project should be funded from the classical

perspective

What is the value of options theory in this case? Real options can give insights into both tactical and strategic management decision making

From a tactical perspective, the traditional NPV is higher for a big bang implementationthan for either of the other two staged options. This suggests that the single projectshould be the best deployment strategy

With real options, however, the 510 deployment has a higher expected value. Thismitigates the risk while maximizing the return of the systems

From a strategic perspective, real options expand the NPV of the DMC project withCRM by $2.5M. This is the money you expect to gain, or not lose, since you have theoption

Compared to other projects with similar NPVs, the option premium makes the projecteven more attractive Use an expanded profitability index to compare projects

The value of strategic options can be very large, so use conservative assumptions: limitthe time horizon and upside, etc.

Teradata can potentially use its knowledge of options to price the flexibility of its EDWsystems

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