902 Words Mar 26th, 2013 4 Pages
Southwest “Winglets” Case

Expected Future Cash Flow of Blended Winglet Project
The cash flow estimations for this project were based on assumptions gleaned from our engineering department, flight operations department, and facilities department. From our initial investment data, we assumed a winglet cost of $700,000 per aircraft, installation of $56,000 per aircraft, and an additional day of downtime for each aircraft at $5,000 per day. The total value of the winglet installation per aircraft was $761,000 which was depreciated over a 7-year modified MARCS depreciation schedule.

In addition to winglet installation, facility upgrade charges were deemed necessary by our Facilities Director. The final estimate for facilities
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We used this calculation of WACC as our discount rate on the expected cash flows from the Winglets project.

The formula for WACC is given as: WACC = wdrd(1-T) + wsrs

in which wd is the proportion of Southwest’s assets financed by debt, ws is the proportion of Southwest’s assets financed by equity, rd is the required return on debt, rs is the required return on equity, and T is Southwest’s marginal tax rate.
(a) Cost of Debt and Equity

To calculate the cost of debt and equity for this project, we combined the risk-free rate with a risk premium based on the market risk premium and the riskiness of Southwest Airlines.

For the risk-free rate (rRF) we used the yield for a 20-year treasury bond in 2002: rRF2002 = 5.86%.

To find the cost of equity we used the formula rs = rRF + beta*MRP in which rRF2002 = 5.86% and the Market Risk Premium (MRP) = 5% as calculated by the Southwest Airlines finance department. We then calculated the beta for Southwest Airlines based on a regression analysis of five-year monthly returns on Southwest stock from January 1997 to January 2002, compared with the S&P 500 returns over the same period. This regression analysis indicated that Beta = .2219. Therefore,

rs = 5.86% + (.2219)(5%) = 6.9695%

(b) Weight of Debt and Equity

We calculated the proportions of debt and equity for the project based on the market value of the debt and equity held by Southwest Airlines in spring 2002. Total

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