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