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
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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
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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
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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.
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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.
Summary
– the change process and lessons learned
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.
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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.
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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.
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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.
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Summary
– the change process and lessons learned
Rewarding risk taking
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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.
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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?
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