## Tuesday, January 17, 2012

### Death by 1,000 Cuts

Assume we own an airline and our airplane is about to pull away from the gate. At this point, a lot of incurred costs have been set – aircraft, salaries, maintenance, gate fees, etc.
At the last moment a potential passenger shows up. The costs for this one additional passenger are minimal – a slight increase in fuel due to the extra weight, a couple of soft drinks, an additional snack, and that is about it.
If we determine that these additional costs related to this one passenger (the technical term is “variable costs”) are  ²20 (the symbol ² representing Treasury Café monetary units), then in theory we should be willing to board that passenger so long as the fare exceeds that amount, i.e. something ²21 or greater.
This is due to the fact that there will be some contribution to fixed costs (at least ²1).
A Time and Place
This type of decision is called “marginal” or “incremental”, in that we are deciding based on one passenger at one particular point in time.
However, by its nature, the logic of marginal analysis is not well suited to extrapolation.
For example, if we price all of our airline tickets at ²21, then we would make ²1 per passenger on the airplane. If our airplane held 100 people, we would thus contribute ²100 towards our fixed costs.
This is all fine and dandy, unless it so happens that our fixed costs for this flight are ²500. If this were the case we would lose ²400 on the flight. This is not a recipe for long-term success.
Thus, we need to make sure we are not making decisions based on a marginal approach when the fact is we are making them for a longer term.
Marginal Practices Create Complexities
For our airplane, in order to cover fixed costs of ²500, then we need to make ²5 per passenger on average (assume returns of and on capital are included in the ²500 figure for simplicity).
So while in theory we are supposed to accept the fare from the one last passenger that contributes ²1, this raises several complications.
First, the price for all the other seats needs to be slightly higher to cover the ²4 we did not earn from the last person. Thus, if we know we are going to employ marginal economic thinking when the plane is pulling away from the gate, we need to price other seats accordingly in order to hit our ²5 average.
Second, once people know of this pricing pattern, we will likely have future flights with more of folks showing up for ²1 pricing versus our needed ²5. The “full-fare” prices then need to also adjust accordingly to account for this.
This simple example illustrates that analysis is not just a simple mathematical exercise. The decision today can affect many tomorrows, a characteristic known as “path-dependency”. Since we are going to set fare prices for future flights, our estimate of “full-fare” vs. “marginal-fare” passengers introduces probability and uncertainty into our pricing decision.
There are other situations where we might mistake long-term decisions for marginal ones.
Financing Mirages
Take lease vs. buy analysis. We perform this analysis assuming 100% debt financing. We do this for a good reason, because leases are debt-like financial obligations, and will be counted as debt for purposes of most financial covenants and ratings agency assessments. If we can lease the asset at a 5% rate and borrow at 6%, we should lease. If we can borrow at 4%, we should buy and finance ourselves.
However, either way we can’t just simply stop the analysis there. If we have possession of ²1,000 in assets, financed at 50/50 debt and equity, and through the lease vs. buy exercise we find leasing more attractive, so we then lease the next ²1,000, we now find ourselves at 75/25 debt and equity rather than 50/50. This change in our capital structure is going to impact our credit rating and our financial covenants. It certainly has impacted our risk position.
A series of seemingly “one-off” transactions has now snowballed into a major long-term impact.
Strategic Mirages
Another common place where incremental thinking can go awry is in strategic situations.
If we are a firm in a line of business where our required equity return (as determined using one of the thousand variations of the Capital Asset Pricing Model) is 12% and cost of debt is 6% at a 50/50 capital structure with a 50% tax rate, our weighted average after tax cost of capital is 7.5%.
We then purchase a line of business different than our current one. Let’s assume this is a riskier business, so the required equity return is 18% at a 50/50 capital structure. Assuming the same debt cost, our weighted average cost of capital is 10.5%.
Since at the outset, the cost of capital is 7.5%, and the new line of business is small, some will simply use the existing cost of capital to value the investment in this new line. As long as it is a very small piece of the whole pie, it is probably not terribly important.
But if the new line takes off, and becomes half of our company, then we find we have a weighted average cost of capital of 9%. Since the investments were all made to clear a hurdle of only 7.5%, our investors now find we are under earning by 1.5%.
This will not make them happy.
Wear Both Hats
In order to avoid the problems above, we need to analyze situations not only in their incremental form, but also as-if they are in long-term form as well. Even if they are not, we need to pretend that they are.
If we are going to invest in an asset via a lease, then we need to anticipate investing in a future asset via 100% equity. We need to make sure that the returns from the lease investment is such that it would be achievable as if it were financed at our target 50/50 capital structure.
If we do not do this, we may never make that all-equity investment, if only because the return hurdles are so much higher they might not be achievable.
For our strategic investment, while we might have access to 7.5% money, we still need to ensure that the new line of business will be economical as if it were financed by 10.5% money. Or, we need to make sure we realize and are confident that a less than 10.5% investment today will be made up for tomorrow with a greater than 10.5% investment.
Key Takeaways
When considering incremental or on-the-margin opportunities, we need to make sure we analyze them two ways, not only incrementally but as-if it is a long-term decision as well.
Questions
·       Can you recall a time when incremental analysis was used inappropriately in your organization?