Chapter 2

The Change Process

A framework for change

It always takes a long time to change from one paradigm to another.

Inertia is not only a law of physics. It applies to organizational change too.

The airbus industrie experience

Complex and financially oriented as we attempt to explicitly.

Background on the problem

This signaling between the buyer and seller has indicated to both parities the respective willingness to bear certain risks in the value chain.

However, these soft attributes had been hard to quantify. While both the manufacturers and the airlines make

detailed assessments of the probable life cycle costs, a guarantee caps the downside risk for the airline.

It also represents a contingent liability for the manufacturer. The normal procedure was for the airline to discount all the

costs and revenues associated with a project at its weighted average cost of capital ( WACC ) or a hurdle rate.

In this case, thinking that the maintenance cost stream would be less risky if guaranteed, they would discount it at the cost of debt rather than WACC.

The beginning of a new approach

Another problem was the airline’s desire to use a “ hurdle rate ” rather than WACC in their analysis.

Agency and organizational issues

There was a long history of unintentionally including in the contract, concessions that at the time were perceived small, but later turned out to be significant financial liabilities.

It seemed management and negotiators were naturally overly optimistic and hopeful about how the future would unfold with regard to these risks.

The opportunity – a sponsor at the highest level

There was a companywide drive to become more financially transparent.

A type of hysteresis is at play – these was a time lag between airline management making a decision and the effect of that decision on an airline’s fleet of aircraft.

Choosing our weapon

I could in fact see many uses for ROA in our work ; the problem was avoiding a “ black box ” impression of the mechanics be modeled using standard spreadsheet software.

Recognizing we did not have the required level of financial engineering skills in-house

To wait and see if any uncertainty would be resolved before signing up for aircraft orders.

This is a classical deferral option. The holder of an option was assured a specified price and

delivery date, whereas another airline would have to negotiate a price and delivery date dependent on the prevailing conditions at that time.

Thus the delivery option was valuable because it resolved two sources of uncertainty for the airline, the price and delivery date.

Have the ability to swap between different aircraft types on the production line – a switching option.

Constructing the model

A key element in the modeling was the number of types of uncertainty.

We recognized three : the price of the aircraft, the waiting time or queue length, and the aircraft PV.

Testing the model

The value of the option was then just the expected value ( the sum of all the outcomes multiplied by their respective probabilities ) discounted back to today.

A technique called a “ no profitable arbitrage ” condition was used to determine the appropriate discount rate for each time step and solved in a recursive manner backward to today.

Quantifying risk One of the most contentious issues in project evaluation is

the choice of the discount rate and therefore the attribution of a level of risk to the project.

Capital Asset Pricing Model ( CAPM ). A market premium is presumed to be paid to shareholders,

above the risk-free rate, for bearing the systematic ( nondiversifiable ) risk associated with an industry or sector.

This rate is then used to discount the operating cash flows associated with a project, making adjustments for the relative financial gearing of the company or project.

In ROA, in contrast to this, risk is quantified simply in terms of the market volatility of the returns on the underlying asset.

With real options, as the underlying asset is often not traded, a proxy for volatility has to be found.

This proxy can be a Monte Carlo simulation of the value of the project, another traded asset, or a synthetic portfolio of assets.

Thus the volatility of stock returns was a possible proxy for the volatility of aircraft returns or the PV of an aircraft in service with an airline.

Second, we looked at used aircraft transaction data in the industry.

Third, we created a theoretical model based on the operating cost and passenger revenue stream of an aircraft over its life.

Having three different methods to measure volatility of the asset, all of which gave similar answer.

Rolling out the model – internally

With hindsight, we realized we had made a mistake by not giving management an ownership role during the model development stage.

I recognized that I would now have to focus almost entirely on an implementation plan.

Integrating real options analysis into the sales process and the role of marketing

The tactical issues involved in closing a deal always attracted greater management attention than the long-term strategic process of marketing a family of aircraft with all its attributes.

An unexpected benefit – setting the bigger picture around the problem

With airlines recognizing the value of flexibility.

Helping contract directors identify and mitigate risk in contractual language

A common bias affecting negotiators is overconfidence.

They tend to overestimate the likelihood of achieving a positive outcome.

Negotiators overestimate the upside and underestimate the downside in contingent contracts.

Coupling marketing and financing activity during the sales process

The Fleet Planning group could make a decision to purchase assets with no regard for the way it would be financed.

The working relationships between the manufacturer and airlines were such that the Marketing teams had a close relationship with Fleet Planning and the Finance team with the Treasury, with very little overlap.

Building on our real options expertise

Contingencies, where necessary, have been quantified stochastically using Monte Carlo analysis or probability theory.

This can often be compared to decision tree analysis.

In real options, the correct discount rate is determined through the “ risk neutral ” valuation.

Summary – the change process and lessons learned

Taking aim

When you first introduce real options to your organization, use an application where you believe you can show clear evidence of the benefits of the analysis.

Think of it as purchasing an option on the skill set to solve many more ( and bigger ) problems in the future.

Sponsorship

Change occurs most easily from the top down.

It’s key to find a sponsor at the highest level, but recognize that top management have sport time horizons.

Summary – the change process and lessons learned

Inertia Don’t underestimate your company’s ability to keep

going in the same direction. Recognize that people often have a vested interest

in maintaining the status quo. A recent survey found that only 20 percent of

change programs within companies are fully successful.

However companies that had internal change centers, and were used to change, did much better.

Summary – the change process and lessons learned

External help In most companies, people find it easier to

accept that an existing process can be improved on from an outside source.

The cost of a consultant also provides management with an added incentive to make the change process work.

In addition, paying for a consultant gives the expectation that the advice is valuable.

They complement each other’s strengths, and it becomes a much more difficult process to ignore their findings.

Summary – the change process and lessons learned

Intuition versus analysis Don’t just assume that being right will result in

company buy-in. Most top managers are intuitive and heuristic,

these are often attributes that we pay managers for having.

Use the model to confirm and support intuition where possible, rather than pointing out where intuition fails.

Summary – the change process and lessons learned

Managing the model A model has to be explainable for the owner,

users, and management. Use lots of analogies. It is always good to triangulate and bracket.

Summary – the change process and lessons learned

Rewarding risk taking

Managers need to know that they will be rewarded for taking calculated risks beyond what the company is used to.

Summary – the change process and lessons learned

Corporate finance and company structure

It is, however, the operating units that are exposed to and manage the market uncertainty ( and private risk ), that find ROA of value.

Practitioners of real options should search out and develop a real options champion within the Treasury group.

Summary – the change process and lessons learned

Competitive issues Are you “ hardening up ” an attribute you have a

comparative advantage in? What are the implications for competitor, customer, and supplier behavior?

If negotiations with customers or suppliers are involved, it is beneficial to share the analysis and / or the model? What signals do you wish to send to your competitors?

Summary – the change process and lessons learned