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 were estimated at $2,100. Since the rise in costs of 3% applied to all costs except fuel, we assumed over the life of the project that fuel savings from incorporating the winglets was $142,800 each year.
The deprecation over the life of the winglets was determined using the 7-year MACRS method. However, the Job Creation and Worker Assistance Act of 2002 allowed for an additional 50% of the project to be depreciated in the first year. The depreciation schedule used for the Winglets project is illustrated in Appendix 1. With a marginal tax rate of 39%, the final net income over the life of the project is also given in Appendix 1. The expected future net cash flows were then found from summing the above costs and savings and adding back in depreciation for that year. Finally, in year 20, the expected net salvage value at the end of the project was added back into the expected future cash flow for year 20. Using these project implementation costs, the expected return, or internal rate of return, on the Winglets project, is 15%.
Several assumptions were made to calculate the weighted average cost of capital. According to Note 9