MBA201a: Economic CostsEconomic versus accounting costsOpportunity costsOpportunity cost examplesOpportunity cost example: airline fuel hedgesAirline jet fuel hedge exampleSouthwest’s decision if it’s un-hedgedSouthwest’s decision if it’s hedgedSlide 9Fuel hedge positions of major US airlinesJet fuel and crude oil pricesSouthwest hedging: what’s the lesson?Decision trees and sunk costsMBA201a: Economic CostsProfessor Wolfram MBA201a - Fall 2009 Page 2Economic versus accounting costs–We will discuss how economists and accountants have different motives in thinking about costs.•Accountants are trying to keep track of them;•Economists are trying to make sound strategic decisions on the basis of them.–Economic costs include opportunity costs & exclude sunk costs.Professor Wolfram MBA201a - Fall 2009 Page 3Opportunity costs–Payoffs from an action must be judged against the best alternative action.–Make sure you think of all the possible alternatives at a decision node,–… and think through the implications of each node.–Acquisition costs are irrelevant to opportunity costs.–Economic costs include opportunity costs.Professor Wolfram MBA201a - Fall 2009 Page 4Opportunity cost examples–What are the major costs associated with attending Haas for you?–What is the cost to Hertz of a car that is returned late?–What is the value of your frequent flyer miles?Professor Wolfram MBA201a - Fall 2009 Page 5Opportunity cost example: airline fuel hedges–A number of the airlines buy hedges on jet fuel costs.•For instance, if jet fuel prices are trading at $1/gallon, an airline may hedge possible price increases by purchasing a financial option that allows it to buy 500 million gallons of fuel at that price in the future.•If the jet fuel price falls below $1/gallon, the airline is out what they paid for the hedge and they buy fuel at the lower spot price.•If the jet fuel price goes above $1/gallon, they can purchase 500 million gallons at $1/gallon.Professor Wolfram MBA201a - Fall 2009 Page 6Airline jet fuel hedge example–Southwest Airlines currently holds options allowing them to purchase jet fuel at a price of $1.25/gallon.–Imagine that it has a route for which its net revenue is equivalent to $1.25/gallon.* In other words, the route is only profitable if the jet fuel price is at or below $1.25.–Should Southwest’s decision to fly that route depend on whether or not it has hedged its fuel costs?* For instance, imagine a route where SWA has non-fuel costs of $5,000 per flight. Its planes get roughly .25 miles/gallon, so if the route is 500 miles, it’s using 4*500 = 2000 gallons of fuel at a cost of $1.25*2000=$2,500. If it usually carries 100 passengers who generate net revenue of $75 apiece, its passengers are paying $7,500. Net revenues on the route are negative unless fuel is less than or equal to $1.25/gallon.Professor Wolfram MBA201a - Fall 2009 Page 7Southwest’s decision if it’s un-hedgedJet fuel price $1.50 [p=.5]Drop routeBuy spot, operate route Drop routeNo hedgesJet fuel price $1.10 [p=.5]Buy fuel in spot market, operate route0$.15/gallon0-$.25/gallonProfessor Wolfram MBA201a - Fall 2009 Page 8Southwest’s decision if it’s hedgedJet fuel price $1.50 [p=.5]Exercise options, drop route, resell fuelBuy spot, operate route Drop routeBuy hedges at $1.25Jet fuel price $1.10 [p=.5]Exercise options, operate route$.25/gallon0$.15/gallon0Professor Wolfram MBA201a - Fall 2009 Page 9Southwest’s decision if it’s hedgedJet fuel price $1.50 [p=.5]Exercise options, drop route, resell fuelBuy spot, operate route Drop routeBuy hedges at $1.25Jet fuel price $1.10 [p=.5]Exercise options, operate route$.25/gallon0$.15/gallon0Although SWA’s acquisition cost for jet fuel depends on whether it has hedges,its opportunity cost of using jet fuel reflects the spot price in either case.Professor Wolfram MBA201a - Fall 2009 Page 10Fuel hedge positions of major US airlines2006 2007 2008 2009Southwest70% @ $36/barrel55% @ $37/barrel35% @ $37/ barrel30% @ $39/barrelAlaska45% @ $40/barrel20% @ $45/barrel7% @ $49/barrel0%AirTran25% @ $56/barrel16% @ $59/barrel0% 0%JetBlue16% @ $68/barrel0% 0% 0%American18% @ $60/barrel0% 0% 0%US Airways13% @ $67/barrel0% 0% 0%Frontier4% @ $62/barrel0% 0% 0%Continental/Delta/ Northwest0% 0% 0% 0%Professor Wolfram MBA201a - Fall 2009 Page 11Jet fuel and crude oil pricesSouthwest hedging: what’s the lesson?–Southwest’s accounting profits have been hugely affected by it’s hedging position.–But it’s economic decisions most likely have not been influenced.Professor Wolfram MBA201a - Fall 2009 Page 12Professor Wolfram MBA201a - Fall 2009 Page 13Decision trees and sunk costsLesson: What’s behind you is not important.Movie will be a hit [p=0.8]Movie will be a flop [p=0.2]Acquire licensefor new product-$.5mm0-$1mm + $2.5mmDon’t develop productDevelop productDevelop product0-$1mm + $.1mmDon’t develop
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