The Value of Flexibility at
Global Airlines: Real Options
and EDW and CRM
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 positive
impact on the cos. Fortunes.
Bud Hall the cos. CIO paged Bergin Director (IT) Finance for a urgent
meeting
Issues
Cost cutting had hurt the qualtiy of service
Customer survey downgrade by three levels + Member BoDs
experience
Time to consider data mart project proposed by Bergin. Though
ve NPV its option value needs to be evaluated as bergin has been
arguing so many times
Data Warehousing
Facts DM Consolidation
Currently, 12 Oracle Data Marts and 3 IBM data marts were fully
depreciated So 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 and
does 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
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
Facts DM Consolidation-Scenarios
Big Bang Consolidate all 15 DMs in one go
Two stage: First consolidate 5 DMs and after review consolidate the
rest 10
Three Stage- First consolidate 5 DMs, then another 5 and then last 5.
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?
Options in a Nut Shell
The range of possible
outcomes can improve
dramatically when you have an
option
The options value is just the
difference between the
expected value of the project
with the option and without
What does the $ value of an
option mean?
Passive Management
Active Management
Probability
It is the money you expect to
gain since you have the option
NPV
Real Options Analysis Framework
1.
Business Discovery: Understand the business, and basic cost and revenue
drivers that the new technology project is expected to impact. Make judgments
and/or assumptions about how the technology project will impact cost and
revenue drivers to improve business performance.
2.
Traditional NPV/ROI Analysis: Perform traditional NPV/ROI analysis
discussed in the ROI Analysis framework. The implementation costs for projects
are the exercise prices for those real options. The present value (PV) of the
expected incremental free cash flows after the firm has implemented the
technology project is the underlying asset for the real options analysis.
3.
Identify Embedded Options: Identify which options are embedded
operating options and strategic growth options.
4.
Volatility Determination: Determine the volatility (standard deviation of the
logarithmic 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 the
traditional NPV from the expanded NPV. The option premium represents the
value of the management flexibility.
6.
Sensitivity Analysis: Perform sensitivity analysis (Excel tools) to
incorporate varying volatilities to generate a range of possible outcomes for real
options valuation.
Real Options
Analysis
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 annual
project returns.
Statistic
Summary Statistics
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%
2.993064949
35%
8.03%
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%
Kurtosis
Median
Global Airlines Case Scenario
6 months
6 months
6 months
Phase I
15 data marts
Phase I
Phase II
5 data marts
10 data marts
Phase I
Phase II
Phase III
5 data marts
5 data marts
5 data marts
Tactical Options Decision Tree (510 Project)
t=0
Phase I
Phase II
6 months
12 months
t=1
Successful EDW
Consolidate
10 data marts
Consolidate
5 data marts
Success
Failure
No additional
consolidation
Consolidate?
Failure
No additional
consolidation
Keep Do nothing
existing
system
Decision
Outcome
Tactical Options Decision Tree (555 Project)
Phase II
Phase I
t=0
6 months
Phase III
6 months
t=1
t=2
6 months
Successful EDW
Consolidate
5 data marts
Success
Consolidate
5 data marts
No additional
consolidation
Success
Consolidate
5 data marts
No additional
consolidation
Consolidate?
Failure
No additional
consolidation
Keep Do nothing
existing
system
Decision
Failure
Outcome
Failure No additional
consolidation
Facts Analytical CRM Project
To enable personalize maketing offers and promotions
Create marketing campaigns targeted at 400,000 active GA frequent
fliers..
Camapaigns would run quarterly and would aim to up silver wing
customers 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, Platinum 5%
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
Thousands
Traditional NPV Analysis
$12,000
$10,000
NPV
$8,000
$6,000
$4,000
$2,000
$-
DMC Project
IRR = 16.7%
DMC Project + CRM
IRR = 35.6%
Facts Analytical CRM Project Risk Factors
Increase in Take rate from 2% to 5%
Increase in average quarterly spending by 15%
Real Options Analysis
Project Volatility Determination Using Monte Carlo Simulations
Total Teradata Solution Year 0 Cash Flow -- Depreciable Basis for 5-Year MACRS
Cost Structure Associated with Implementation of Data Warehouse -- December 31st Abandon Data Marts
Nodes, Software, Disks $
Profession Services $
Yearly Total $
6,650,000
4,200,000
13,292,985
Excel solution
walkthrough . . .
Investment Cash Outflow at T=0 = Depreciable Basis
Cash Flow Statement
Old Configuration
Salary & Benefits
Training
Professional Services (consulting)
Maintenance/upgrades
Non-personnel support
Total
times (1-tax rate)
less tax rate times depreciation
total
Year 0
New Configuration
Salary & Benefits
Training
Professional Services (consulting)
Maintenance/upgrades
Non-personnel support
Total
times (1-tax rate)
less tax rate times depreciation
total $
Incremental Cash Flow $
Year 0
(13,292,985)
(13,292,985)
Net Present Value (NPV) $
(2,231,488)
Internal Rate of Return (IRR)
Year 1
13,300,000
860,000
11,600,000
25,760,000
15,971,200
15,971,200
$
$
$
$
$
$
$
$
$
$
Year 1
13,300,000
860,000
11,600,000
25,760,000
15,971,200
(1,010,267)
14,960,933
1,010,267
$
$
$
$
$
$
$
$
$
Year 2
13,965,000
860,000
12,064,000
26,889,000
16,671,180
16,671,180
$
$
$
$
$
$
$
$
$
Year 3
14,663,250
860,000
12,546,560
28,069,810
17,403,282
17,403,282
$
$
Year 2
9,329,096
720,000
$
$
Year 3
9,795,550
720,000
$
$
$
$
$
$
$
1,400,000
7,787,520
19,703,070
12,215,904
(2,424,640)
9,791,263
7,612,019
11,929,742
$
1,400,000
$
7,488,000
$ 18,937,096
$ 11,740,999
$ (1,616,427)
$ 10,124,572
$
6,546,608
5.6%
PV of Incremental Cash Flow
NPV without exercising option $
$
$
$
$
$
$
$
$
$
V2
$ 12,610,107
V1
38,584,476
Project Return
Mean
5.55%
5.55%
Std. Deviation
0.00%
18.07%
Real Options: Basic Framework
Traditional
NPV of Pilot
Project
Expanded
NPV (ENPV)
Traditional
NPV
Option
Premium
Full EDW
Option Value
Expanded NPV =
Traditional
NPV of a Pilot
Project
+ Option value of a
Full EDW
Project
Option Premium = Expanded NPV Traditional NPV
DM Expanded NPV Calculation
Real Options Program (Three Stage)
Input Parameters (Fill in green and yellow boxes)
Risk-Free Int Rate
Required Return
Steps
Option
Project 1 - 5DM
Project 2 - 5DM
Project 3 - 5DM
Time
0
1
2
==>>
==>>
==>>
2.00%
14%
52
Volatility
18.32%
16.66%
17.57%
Time to Expire (months)
0
6
12
Option # Option Description
Option Type
None Project 1 (5DM)
1 Project 2 (5DM)
2 Project 3 (5DM)
Nested CALL
Nested CALL
Real CALL
PV of incremental
CF
$
6,256,600
$
6,349,157
$
6,441,311
Total NPV of the Three Stage Program
Traditional Approach
NPV - Project 1 (5 DMs)
NPV - Project 2 (5 DMs)
NPV - Project 3 (5 DMs)
Total NPV of the Program (Tradtional NPV)
$
$
$
$
(98,400)
381,650
(233,776)
49,473
Real Option Approach
Total NPV of the Program (Expanded NPV) $
660,753
Option Premium $
611,280
Investment
(Strike Price)
$
6,355,000
$
5,940,000
$
6,710,000
Volatility
18.32%
16.66%
17.57%
Time to expire
(in years)
0
0.5
1
Real Options Summary
Single-Project
Strategy
Traditional NPV $
Option Premium $
Expanded NPV
987,263
-
Two-Project
Strategy
$
$
$
908,752
349,231
1,257,983
Three-Project
Strategy
$
$
$
49,473
611,280
660,753
Tactical Real Options Summary
s
sand
Thou
NPV
Option Premium
Expanded
NPV
Traditional
NPV
Single-Project Strategy
Two-Project Strategy
Three-Project Strategy
Sensitivity Analysis
$4,000,000
Expanded NPV
$3,500,000
$3,000,000
$2,500,000
Two Stage
$2,000,000
Three Stage
Traditional
$1,500,000
$1,000,000
$500,000
$0.00%
20.00%
40.00%
60.00%
Volatility
80.00%
100.00%
CRM Expanded NPV Calculation
Real Options Program (Two Stage) + CRM
Input Parameters (Fill in green and yellow boxes)
Risk-Free Int Rate
Required Return
Steps
Option
Project 1 - 5DM
Project 2 - 10DM
Project 3 - CRM
Time
0
1
2
2.00%
14%
52
==>>
==>>
==>>
Option #
None
1
2
Volatility
18.32%
18.07%
45.29%
Option Description
Project 1 (5DM)
Project 2 (10 DM)
Project 3 (CRM)
Time to Expire (months)
0.0000001
6
18
Option Type
Nested CALL
Nested CALL
Real CALL
PV of incremental
$
6,256,600
$
11,929,742
$
18,822,012
Total NPV of the Two Stage Program + CRM
Traditional Approach
NPV - Project 1 (5 DMs)
NPV - Project 2 (10 DMs)
NPV - Project 3 (CRM)
Total NPV of the Program (Tradtional NPV)
$
$
$
$
(98,400)
1,007,153
9,594,392
10,503,144
Real Option Approach
Total NPV of the Program (Expanded NPV) $
12,952,179
Option Premium $
2,449,035
$
$
$
Investment
6,355,000
10,850,000
7,000,000
Volatility
18.32%
18.07%
45.29%
Time to expire
0
0.5
1.5
Real Options Summary + CRM
DM Traditional
CRM Traditional NPV
Option Premium
Expanded NPV
Two-Project
Strategy + CRM
$
908,752
$
9,594,392
$
2,449,035
$
12,952,179
Thousands
Real Options Graphical Summary
$14,000
$12,000
Option Premium
NPV
$10,000
$8,000
Expanded
NPV
CRM Traditional
NPV
$6,000
$4,000
$2,000
DM Traditional NPV
$Two-Project Strategy + CRM
Thousands
DMC and CRM with Real Options
$14,000
$12,000
NPV
$10,000
$8,000
Option Premium
Traditional NPV
$6,000
$4,000
$2,000
$-
DMC Project
DMC Project + CRM
Real Options Case Takeaways
The classical NPV of the CRM project with the data mart consolidation (DMC) is very
large compared to just the classical NPV of the DMC
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 implementation
than for either of the other two staged options. This suggests that the single project
should be the best deployment strategy
With real options, however, the 510 deployment has a higher expected value. This
mitigates the risk while maximizing the return of the systems
From a strategic perspective, real options expand the NPV of the DMC project with
CRM by $2.5M. This is the money you expect to gain, or not lose, since you have the
option
Compared to other projects with similar NPVs, the option premium makes the project
even more attractive
This suggests that the full EDW and CRM project should be funded from the classical
perspective
Use an expanded profitability index to compare projects
The value of strategic options can be very large, so use conservative assumptions: limit
the time horizon and upside, etc.
Teradata can potentially use its knowledge of options to price the flexibility of its EDW
systems