Procurement Decisions in the Airline Industry

MA-Thesis / Master von Tobias Rudeloff

Introduction:

Over the last two decades, real options analysis (ROA) has become a fundamental part of project evaluation. Its increasing use in academia and corporations as well as its application to a wide range of industries make it a valuable tool in finance and accounting departments around the world. Classical capital budgeting approaches like net present value (NPV) techniques do not account for additional flexibility and are therefore a very static measurement.

In addition to this, a further core factor is the strategic aspect of the investment decision. Companies often make decisions according to strategic reasons. This raises the question of how the bargaining power is divided between a seller and a buyer. Furthermore, the influence of the hold-up problem on the two involved players is analyzed. Finally, the trade surplus of the investment is divided between the seller on the one hand and the buyer on the other hand using a game theoretic approach to model this relationship. The airline industry is examined in this paper as it offers many possibilities to apply and explain the concepts of real options and bargaining in bilateral negotiations.

This paper sets out to analyze the value of flexibility of an investment decision and discusses, in a second step, how the strategic power between the two parties involved is allocated. In academic literature, limited research has been done to find out about the combination of a real options analysis and the distribution of the trade surplus between the different players involved.

This presents the following questions: Does an option in terms of the purchase of an aircraft have additional value in comparison to a classical and inflexible ‘buy now” decision for an airline? If this is the case, how much is this value worth and how is the trade surplus distributed between the two parties involved? Are there any hold-up problems? The following chapters will examine and answer these issues.

Chapter two deals with a literature review on standard real options analysis in general and the airline sector in particular. In chapter three, background information about the airline industry is given and it is stressed why this sector is used for the capital budgeting approach. Chapter four covers the methodology that is used in chapter five. In this chapter, a case study involving the purchase decision of an aircraft is discussed using different methods to analyze the ‘commit-now” and purchase option scenario. Chapter six introduces the strategic aspects discussed in this paper and gives a literature review on bargaining. In chapter seven, the methodology to analyze the hold-up problem as well as the bargaining problem is explained. In a last step, chapter eight applies these concepts to the relationship between an aircraft manufacturer and an airline. Chapter nine concludes and proposes potential future research interests.

Table of Contents:

Text Sample:

Chapter 5.7, Problems and limitations:

First of all, it has to be said that every calculation can only be as good as its input parameters. The case study in this chapter makes many assumptions concerning fuel prices, revenues, cost of capital, etc. The cash-outflows are average expenses from all American airline companies. Low-cost carriers usually have much lower operating expenses than incumbent airlines which affects the value of the option. Moreover, taxes were not taken into account to calculate the value of the investment. Tax payments would decrease the value of the project.

Besides, only two factors of uncertainty were taken into consideration when undertaking the Monte Carlo Simulation. However, there are more uncertainties than only fuel prices and revenues, for example exchange rates, interest rates and yields.

In order to be able to make certain assumptions for the hold-up problem and the bargaining problem in chapters seven and eight, the lead time for the purchase option scenario is one year less than the lead time in the ‘commit-now’ case. This aspect leads to a biased value in favor of the real options scenario. The value for the purchase option with a three year lead time equals 10.48 million USD which is 4.47 million USD less than the value of the originally computed scenario in this chapter.A detailed calculation of the case with three years lead time can be found in the appendix.

Moreover, the standard deviation of the project takes into account two lognormal distributions (fuel prices and revenues). However, on closer examination, it has to be said that the combination of two lognormal distributions will not lead to a combined lognormal distribution. Thus, this assumption of the Black-Scholes formula has to be facilitated.

It can be observed from figure six that the relationship between ln (PV3/PV0) has a long tail on the left-hand side. This observation contradicts the fact that a log-normal distribution usually has a longer tail on the right hand side compared to a normal distribution. It supports that the lognormal distribution for the volatility - which is assumed by Black and Scholes - has to be facilitated.

Besides, the calculated standard deviation is only a one year standard deviation. As the life of the option is three years, the value of the purchase option may be underestimated. Moreover, it was assumed that the volatility of the project remains the same over the life of the option.

Furthermore, Brach says that a lognormal distribution which is presumed by the Black-Scholes formula is unlikely to correctly illustrate the stochastic process of the asset that produces the cash flows. There may occur jumps which contradict the symmetric random walk.

The Binomial Option Pricing Model has the drawback that the speed of determination of the option value is slow when many calculations are performed at the same time. The problem of the Black and Scholes method is that it can only be used for European style options as the exercise before the expiration date cannot be valued.

All in all, Black-Scholes and Binomial method have both their pitfalls but can be used to approximate the value of the purchase option in this case study.