Airlines Case

Based on the assumptions and estimations James Baron made, he is able to have a NPV (Net Present Value) of each option to decide which option to undertake. It is good way to NPV rule when the projects are mutually exclusive as it gives the direct profitability of each project by magnitude.

NPV rule is also consistent with the capital budgeting goal of shareholder wealth maximization. He takes in the consideration of the uncertainty of the introduction of PJ-2 and PJ-3, and decides to use a higher cost of capital. By going this, risk is adjusted to certain degree.

However, he fails to consider some factor which will have major influence into his estimation data. Firstly, he fails to consider the supply and demand of the airline market. He just assumes the popularity of the Los Angeles-New York route stays unchanged, the taste and the royalty of customers stay constant during the project life. This is a not a good assumption especially in a highly competitive market by a long time horizon.

How confident is his estimation of the passenger load factor, will it stay the same during the competition? By measuring how a change in supply and demand changes the price and quantity, James is able to get a more realistic data in estimation. But these types of analysis are more complicated and time consuming. As a matter of fact, supply and demand is a very important factor in doing predicting the future and need to be adjusted,

Secondly, he adjusts the risk of introduction of PJ-2 and PJ-3 by a large cost of capital. This may help to eliminate the risk to a certain degree but once the failure occurred, it will completely failed analysis. Therefore, some benchmarks maybe done to help with this extreme situation.

For example, some more options can be made to compare with those three options. Say Option D, the PJ-2 and PJ-3 will be introduced one year later than planned. An estimated cash flow can be done by considering this option and hence