Southwest Winglets Case Essays

858 Words Apr 3rd, 2013 4 Pages
MEMO TO: Scott Topping, Director of Finance
DATE: March 31, 2009
SUBJECT: Blended Winglet Project
In order to calculate Southwest’s expected future cash flows from the Blended Winglet project we made specific decisions in setting the cash flows. First, we assumed that the cost of a Winglet is $700,000 per pair. Additionally, we assumed initial costs of: installation downtown per plane of $5,000, an installation cost of $56,000, and a facility modification cost of $1,200. Since costs were expected to rise 3% over the extended life of the project, we calculated this 3% inflation rate into restricted runways savings, which in year one started at $500, and we calculated the 3% inflation rate into maintenance costs, which in year one
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The cost of equity was found using CAPM, with the given market risk premium of 5%, a beta of .88, and risk-free rate of 4.03%. The beta was found by running a regression of Southwest’s percent change in stock price versus the S&P 500’s percent change in stock price for two years (June 28, 2000 to June 28, 2002). The risk-free rate was the return on a ten-year treasury note issued on June 28, 2002, according to the U.S. Treasury’s website. The tax rate of 39% was used to account for tax savings from leverage. In order to calculate the firm’s leverage, the market value of equity was found from the price per share on July 24, 2002 (Yahoo Finance) and the shares outstanding on the balance sheet of the July 10-Q report, as shown in Exhibit X. The debt value was approximated at the book value since data could not be found regarding its market value. This analysis resulted in a debt weight of 11.74% and equity weight of 88.26%. The final approximation for the weighted average cost of capital was 8.64%. Southwest traditionally uses a 5% premium over the weighted average cost of capital as a discount rate for long-term projects. This makes certain that the project will only have a positive net present value and be worth the investment if it gives investors a premium for the additional risk they must take on. The expected return on the project of 14.5% gives a 5.9% premium over the calculated

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