Global Airlines Harvard Case Solution & Analysis

1.) Explain the difference between a (traditional) NPV and an expanded or strategic NPV?

Traditional NPV is the method that is used for making capital budgeting decisions. Traditional NPV is the difference between the amount of an investment and the present value of the future cash flows from an investment. The present value of the future cash flows is calculated by the discounting them at the required rate of return. The main and first step included in the figuring of NPV is the determination of the present estimation of net money inflows from a venture or holding. The net cash flows of present value may be even (that means equal cash inflows in different time periods) or uneven (that means different cash inflows in different time periods). When they are even, present worth may be effectively computed by utilizing the present quality equation of annuity. On the other side if these cash flows are uneven, then we have to figure the present estimation of every individual net cash inflow independently. In the second step of the NPV calculation, initial investment on the project is subtracted from the total present value of cash inflows to arrive at the net present value. If the NPV is positive or zero, only then accept the project and the NPV is negative reject the project. The project should be accepted only in the case if the NPV is positive or zero and the project should be rejected if the NPV is negative. In addition, accept the project with the highest NPV when comparing two or more projects that have positive NPVs.

Traditional NPV enables the management of the company to analyze the time value of money that it will invest. This means that the value of the money increases as the time passes. The value of the future net cash receipts of the projects in "today's money" can be determined when the time values of money concept is incorporated in the calculation of NPV. This helps the company to make proper comparisons among different projects.

Expanded or strategic NPV is the total value of a project that owns one or more options. Expanded or strategic NPV is also defined as the value of the real options in the valuation of an investment. The expanded or strategic NPV is equal to the net present value of an investment on the project plus the value of real option. The real option is a choice or an alternative that becomes available for the company with the business investment opportunity. The opportunities that are included in the real option expand or cease the project if certain conditions arise amongst other available options. Expanded Net Present Value (ENPV) has a much more relevant base for either a feasibility study of any project, an investment and managerial decision rather than simple NPV.

The expected NPV process assumes that all investment decisions are known and the role of the management in the investment process is passive. This unavoidable financing methodology is conflicting with the standards, capacity and dynamic nature of administration. The normal NPV technique in this way is not a substitute to NPV; it’s a complimentary instrument that joins the utilization of true alternative valuation. The strategic or expanded NPV not only incorporates the NPV of expected cash flows from investing immediately and the flexibility value from active management of the firms portfolio of operating the real option but it also incorporates the strategic value from the competitive interaction.

In the strategic and expanded NPV, the investments have two effects on the value of the firms as compared to the wait and see strategy. One is the flexibility or value option effect and the flexibility or value option effect reflects the ability of the management of the company to work under the conditions that are uncertain. Although, the early investment enhances the commitment values of the growth opportunities of the future but it scarifies the flexibility value as compared to the wait and see strategy. Second is the strategic commitment effect that reflects that the early

investment decisions can signal credible commitments that can influence the investment decision of the competitors.

There are three level of planning that have an effect on the strategic or expanded NPV of investment opportunities. Firstly, the appraisal of the project that aims at determining the effect on the NPV of the projected cash flows which results from an establishment of competitive advantage. Secondly, the strategic planning of growth opportunities that captures the flexibility values, which results from the adaptive capabilities of the company by using real option valuation. Finally, competitive advantage that aims at analyzing the strategic value from enhancing, establishing and defending company’s strategic position against the competitors.

Positive expanded NPV investments are expected to yield an excess return that will be above the opportunity cost of capital. An option based on expanded NPV combines the best features of both (DTA) decision tree analysis and the NPV without their drawbacks. Expanded NPV borrows the use of decision nodes from the Decision Tree Analysis (DTA) in modeling flexibility while ...........................

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