Southwest Airlines

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Southwest Airlines

 

As a low-fare airline, Southwest Airlines constantly focuses on ways to improve the efficiency of its operations and maintain a cost structure below that of its competition. In the spring of 2002, Scott Topping, the director of corporate, was approached by Aviation Partners Boeing (APB) regarding an innovative way to save on fuel costs—the installation

of a new technology known as the Blended Winglet.The winglets, made of carbon-graphite, were designed for the Boeing 737-700 aircraft. Southwest currently had 142 planes of this model in its fleet.

The Blended Winglet system was developed by APB, a joint venture between Aviation Partners Inc. and The Boeing Company. The main purpose of the winglet was to reduce turbulence, leading to higher flying efficiency. As a result, the winglets provided three important benefits that allowed the airplane to extend its range, carry a greater payload, and save on fuel consumption. The winglets accomplished this by increasing the spread of the wings’ trailing edge and creating more lift at the wingtips.

To complete his financial analysis, Scott had to verify potential costs and benefits as well as get the approval of the Maintenance Engineering Department, the Flight Operations Department, and the Facilities Department. However, Scott was well aware that regardless of the potential financial benefits, safety was the first priority. This process took several months due to the complexity of the project.

After discussing the project with the requisite departments, Scott made the following estimates of the costs and benefits of the winglet system to Southwest:

■ The winglets, which cost $700,000 a pair, could be installed at an additional cost of $56,000 per aircraft. Installation could be scheduled at each maintenance facility to coincide with regular maintenance. As a result, each aircraft was expected to experience downtime for only one extra day, at a cost of $5,000.

■ After considering the short- and long-term effects of the winglets, the Maintenance Engineering Department estimated that, on average, repair costs would average $2,100 yearly per aircraft, due primarily to incidental damage.

■ The increased wingspan was expected to allow each of Southwest’s aircraft to fly up to 115 nautical miles further and to decrease fuel usage by 4% to 6%. This meant that Southwest could expect to save 178,500 gallons of jet fuel per airplane per year.

■ Flight Operations23 estimated that the additional lift capability provided by the winglets would reduce Southwest’s costs of using restricted runways, with an estimated savings of $500 per aircraft per year.

■ The Facilities Department assessed the effect of the added wingspan on each of the 59 airports Southwest utilized in its current route structure. The department estimated that the necessary facilities modifications could be achieved at a onetime cost of about $1,200 per aircraft.

■ The Blended Winglet project qualified for accelerated tax write-off benefits under the Job Creation and Worker Assistance Act of 2002. With a marginal tax rate of 39% and using a seven-year depreciation schedule (see the table below), Southwest would be allowed to depreciate an additional 50% of the project in the first year.

■ The Blended Winglet project is expected to have a life of at least 20 years, at the end of which the winglets are expected to have a salvage value of $105,000. Assume a jet fuel cost of $0.80 per gallon and a cost of capital of 9.28% in your analysis. Items other than fuel are expected to escalate at a 3% rate. Conduct the analysis on a per-plane basis.

Evaluate the project by analyzing the following:

a. Estimate the project’s annual project free cash flow (FCF) for each of the next 20 years, as well as the initial cash outflow.

b. Calculate the net present value (NPV) and internal rate of return (IRR) of the Blended Winglet project.

c. What is the break-even jet fuel cost for the project? What is the break-even fuel savings in gallons for the project, assuming jet fuel costs $0.80 per gallon?

d. How sensitive is the Blended Winglet project’s NPV to changing assumptions regarding expected future fuel costs and fuel savings? Use scenario analysis to analyze a best-case scenario (jet fuel price of $1.10 per gallon and fuel savings of 214,000 gallons per year) and a worst-case scenario (jet fuel price of $0.50 per gallon and fuel savings of 142,000 gallons per year).

e. What potential risks and benefits do you see that are not incorporated into the quantitative analysis?

f. What is the impact on the project’s NPV or IRR if the winglets have no salvage value?

g. Would you suggest Southwest Airlines undertake this project? Why or why not?