CASE 7: SOUTHWEST AIRLINES

ANSWER:
The net present value (NPV) is simply the sum oI the present values oI a project`s cash
Ilows:
.
) k (1
CF
NPV
t
t
n
0 t

Project L`S NPV is :

Timeline oI project












NET PRESENT VALUE (NPV)


()
0 1 2 3 4 3 6 7
(208) 43 63 32 39 21 13 03
409
321
391
266
130
073
026
10
Question 1 :
What is the project`s NPV assuming Southwest has a discount rate of 10? How do we
interpret the NPV?

Calculation:
-20.8 4.5 6.3 5.2 3.9 2.1 1.3 0.5
(1.10) (1.10)
2
(1.10)
3
(1.10)
4
(1.10)
5
(1.10)
6
(1.10)
7

-20.8 18.2
0


Southwest Airlines is considering to acquiring an additional small route to grab the higher
margin in the niche market oI providing direct Ilight to small cities. So, the Net Present Value
(NPV) of that project is - percent

How do we interpret the NPV?

NPV is used in capital budgeting to analyze the proIitability oI an investment or project. Related
to the case, NPV for that project was negative, so the proposal to acquire an additional small
route should be rejected by Southwest Airlines. It is means that project PV inIlows is lower
than project PV outIlows, so the project cash flows are insufficient to repay the invested
capital and to provide the required rate oI return on the capital (investment) that would subtract
value Irom the Iirm.
Otherwise, iI the project NPV is positive, so the project exactly would generates enough cash to
recover the cost oI the investment and to enable investors to earn their required rates oI return.



ANSWER:
The internal rate oI return (IRR) is the discount rate that Iorces the NPV oI a project to equal
zero; it is the rate oI return the project is expected to generate:

0 1 2 3
CF
0
CF
1
CF
2
CF
3

PVCF
1

PVCF
2

PVCF
3

$0 _ PVs NPV.


Expressed as an equation, we have:

. NPV $0
) IRR (1
CF
: IRR
t
t
n
0 t

IRR
Question :
What is the project`s IRR? How is this measure different from the NPV? What is the
interpretation of this number?
Note that the IRR equation is the same as the NPV equation, except that to Iind the IRR the
equation is solved Ior the particular discount rate, IRR, that Iorces the project`s NPV to equal
zero rather than using the cost oI capital (k) in the denominator and Iinding NPV. Thus, the two
approaches diIIer in only one respect: In the NPV method, a discount rate is speciIied (the
project`s required rate oI return) and the equation is solved Ior NPV, whereas in the IRR
method, the NPV is speciIied to equal zero and the discount rate (IRR) that Iorces this equality
is Iound.
Project`s IRR is 4.8 percent:











- $0 iI IRR 4.8 is used as the discount rate

(Try & Error)


-20.8 4.5 6.3 5.2 3.9 2.1 1.3 0.5
(1.10) (1.10)
2
(1.10)
3
(1.10)
4
(1.10)
5
(1.10)
6
(1.10)
7

-20.8 18.2

0

429
374
432
323
166
098
036
0 1 2 3 4 3 6 7
(208) 43 63 32 39 21 13 03
0



-20.8 4.5 6.3 5.2 3.9 2.1 1.3 0.5
(1.03) (1.03)
2
(1.03)
3
(1.03)
4
(1.03)
5
(1. 03)
6
(1.03)
7

-20.8 21.8
1


-20.8 4.5 6.3 5.2 3.9 2.1 1.3 0.5
(1.04) (1.04)
2
(1.04)
3
(1.04)
4
(1.04)
5
(1.04)
6
(1.04)
7

-20.8 21.24
0



-20.8 4.5 6.3 5.2 3.9 2.1 1.3 0.5
(1.048) (1.048)
2
(1.048)
3
(1.048)
4
(1.048)
5
(1.048)
6
(1.048)
7

-20.8 20.8
0#

The project Internal Rate of Return (IRR) is .

The IRR is a rate oI return used in capital budgeting to measure and compare the proIitability oI
investments. IRR Iorces the project`s NPV to equal zero rather than using the cost oI capital
(hurdle rate) in the denominator and Iinding NPV. Thus, the two approaches differ in only one
respect: In the NPV method, a discount rate is specified (the project`s required rate oI return)
and the equation is solved Ior NPV, whereas in the IRR method, the NPV is specified to
equal zero and the discount rate (IRR) that forces this equality is found.

The projects` IRR is compared to the required rates of return, or costs of capital, which are
the projects` hurdle rates In this case, the IRR (4.8) is less than project hurdle rates which
is 10, so taking the project will impose a cost on current stockholders. In this situation,
Southwest should exactly reject the project



ANSWER:
The payback period is the expected number oI years required to recover a project`s cost. We
calculate the payback by developing the cumulative cash Ilows as shown below Ior Project (in
millions oI dollars):






4 0.9
2.1
4.43 years ~ 4 years 5months 16days
The Southwest Airline will take 4.43 years to cover the initial investment (cost outIlow).

48

(208) 43 63 32 39 21 13
0 1 2 3 4 3 6
Question 3 :
Calculate the project`s Payback Period
(208) (163) (10) (48) (09) (12) (23)




i) ANSWER:







Based on the above cumulative cash Ilow, the Southwest Airline company should not purchase
the additional route because the project still cannot cover its original investment aIter 6 years.
At the end oI year 6, the project still has 2.9 million uncovered cost.
Based on the project APJ, the purchase oI the additional route should be rejected because the
NPV is negative (-2.6 million).
1herefore, there is no conflict between Discounted Payback period and NPV. Both show that
the project have to be rejected.

If conflicting conclusion occurs, means the NPV is negative (-2.6) and the Payback period is
less than 6 years, we would Iollow the NPV indicator`s that is reject the project because the
payback method has two critical deIiciencies:
(i) It ignores the time value oI money; and
(ii) It ignores the cash Ilows that are paid or received aIter payback.



Question :
Assuming Southwest Airlines has required payback period of years and a hurdle rate of
10, should Southwest accept the additional route? Based on the project`s NPV, should it be
accepted? If conflicting conclusions occur, which criteria would you follow?

(208) 409 321 391 266 130 073
(208) (1671)
)
(1130) (739) (493) (363) %%
(208) 43 63 32 39 21 13
0 1 2 3 4 3 6





ConIlicts likely to occur among the three criteria when,

i) In the independent projects:

II the independent projects are being evaluated, the projects should be accepted iI:
i) the NPV Ior the project is positive.
ii) the IRR oI the project is higher than the required rate oI return(cost oI capital).
iii) The payback period Ior the project is less or equal than required payback period.

The conIlict here, iI the project has meet the requirement no iii), but the NPV is
negative and IRR is lower than cost oI capital. Should we accept the project? The
answer is no. The project should not be accepted. This is because, among the three
criteria, the value NPV is very important. II the NPV is negative, the Iuture project will
generate not enough cash inIlows to cover the initial payment. By accepting the
projects, it will reduce the Iirm`s assets and shareholder`s value.
Normally in independent project, the IRR and NPV criteria always lead to the same
accept/reject decision. Whenever a project`s cost oI capital is less than IRR, its NPV is
positive. II cost oI capital is higher than IRR, its NPV is negative.

ii) In the mutual exclusive projects
Mutual exlusive means we have to choose
In the mutual exclusive projects, which projects should we choose iI all the alternative
projects have positive NPV, their IRR is higher than the required rate oI return(cost oI
capital) and their the payback period is less or equal than required payback period?
Let say, there are two projects, Project A and B. NPV A is larger than NPV B, and
IRR A is exceeds IRR B and payback period A is better than payback period B . In this
case deIinitely project A will be accepted because NPV, IRR and Payback period A is
better than B.
Question 5:
When will conflicts likely to occur among the three criteria?

conflict exists iI, the project is better in one criteria but poor in other criteria. For
example, NPV A is higher than NPV B, but IRR A is lower than IRR B. NPV says
choose project A, but IRR says choose project B. Which projects should we choose?
This conIlict arise between IRR and NPV: (1) When project size (or scale) diIIerences
exist, meaning that the cost oI one project is larger than the oI the other, or (2) when
timing diIIerences exist, meaning that the timing oI cash Ilows Irom two projects
diIIer such that most oI the cash Ilows Irom one project come in early years while
most oI the cash Ilows Irom the other project come in later years.
The key to resolving conIlicts between mutually exclusive project is this: How useIul
is it to generate cash Ilows sooner rather than later? The value oI early cash Ilows
depends on the return we earn on those cash Ilows, that is, the rate at which we can
reinvest them. The NPV method implicitly assumes that the rate at which cash Ilows
can be reinvested is the cost oI capital, whereas the IRR method assumes that the Iirm
can reinvest at the IRR. So, the NPV gives better assumption the project`s cash Ilows
can be reinvested at cost oI capital, which means that the APJ method is more
reliable.

ThereIore, we can conclude that iI the projects are independent, the NPV, IRR and
PPP method lead to exactly the same accept/reject decision. However, when
evaluating mutually exclusive projects, especially those that diIIer in scale and/or
timing, the APJ method should be used.
















ANSWER:

i) Calculation the project`s Modified Internal Rate of Return (MIRR) is shown below:












20.8 (1MIRR)
7
35.1
(1MIRR)
7
35.1
20.8

MIRR 1-1.078
MIRR 7

@ L project`s ModiIied Internal Rate oI Return (MIRR) oI Southwest Airline is
7.8.


351
0 1 2 3 4 3 6 7
(208) 43 63 32 39 21 13 03
10
14
23
32
76
101
78
10
(110)
2
(110)
3
(110)
4
(110)
3
(110)
6
v @v
208

Ml88 ?

Question :
Calculate the project`s Modified Internal Rate of Return (MIRR) What critical assumption
does the MIRR that differentiates it from the IRR?



ii) What critical assumption does the MIRR that differentiates it from the IRR?

The MIRR is similar to the IRR, but is theoretically superior in that it overcomes the
weaknesses oI the IRR. The MIRR correctly assumes reinvestment at the project`s cost oI
capital and avoids the problem oI multiple IRRs.

The MIRR is used to look at the possible rate oI return on your investment aIter you have
reinvested your business proIit overtimes.
The MIRR uses much more accurate data than IRR and this makes it much reliable to use. The
Iormula Ior MIRR uses both positive and negative values, the investment Iinance rate, the NPV,
and also the re-investment rate in its calculation.
MIRR uses more accurate data, thereIore, the MIRR will guide our investments saIe and as
proIitable as possible.
Thus, using the IRR could result in a positive NPV (good project), but it could turn out to be a
bad project (NPV is negative) iI the MIRR is used. As a result, having MIRR versus IRR better
reIlects the value oI a project.
This has been proved by our calculation using Southwest Airlines MIRR rate at 7.8. Below
are our calculations. In our calculation we use MIRR rate7.8 to Iind the NPV:-

NPV -20.8 4.5/(1.078)
1
6.3/(1.078)
2
5.2 /(1.078)
3
3.9/(1.078)
4
2.1/(1.078)
5

1.3/(1.078)
6
0.5/(1.078)
7
-20.8 4.17 5.42 4.15 2.89 1.44 0.83 0.3
-1.6
ThereIore, the conclusion here, iI we use the IRR4.8, the NPV is equal to zero, but iI we use
the MIRR7.8 the NPV is negative ($-1.6 millions). ThereIore, the Southwest Airlines should
not accept the additional route.





ANSWER:

IRR4.8 MIRR7.8 Discount rate10
(NPV0) (NPV-$1.6 m) (NPV$-2.6m)

The value oI MIRR (7.8) Ialls between the value oI IRR (4.8) and the value oI discount rate
(10-cost oI capita). The NPV oI MIRR is more than the NPV oI IRR but lesser than the NPV
at discount rate 10.
ThereIore, the MIRR and IRR is less than the hurdle rate(10), deIinitely the new route should
be rejected.


Question 7:
What does the value of MIRR fall relative to the discount the discount rate and IRR?