Case Study of Southwest Airlines Paper Example

Introduction

In a business world largely characterized by cut-throat competition, firms dedicate much of their resources towards innovation to adopt to the changing landscapes of doing business. When it comes to business strategy, firms in the airline industry is are no exception to cut-throat competition as witnessed in the case study of Southwest Airlines

Is your time best spent reading someone else’s essay? Get a 100% original essay FROM A CERTIFIED WRITER!

Save 25%

Corporate Valuation

It is important to understand how much a firm is worth and enterprise valuation simply answers that question. Financial analysts deploy a wide range of ratios, methods, and tools to determine whether a firm's stock is overvalued or undervalued. Equally, this information could prove to be useful to various stakeholders as well as the firm itself.

Southwest Airlines enterprise value, as at the recently concluded quarter (March 2018), stands at $30,603 million. It is important to distinguish enterprise value from market capitalization by noting that the latter only includes common equity. Corporate valuation for the airlines will, therefore, include the market capitalization plus preferred shares and debt and minority interest fewer market securities, cash equivalents, and total cash

Capital Structure

It is always important to review how a given firm finances its operations along with the sources of funds it uses to power its routine activities. The key focus while formulating Southwest Airline's capital structure is on debt and equity.

Total Debt to Total Equity (D/E) ratio for the company is 35.17. This figure is arrived at by dividing Southwest's total of liabilities by its stockholders' equity. D/E ratio measures a company's financial leverage meaning that Southwest stands at 33.17.

Total Debt to Total Capital ratio for Southwest is 26.02. This ratio is arrived at by taking a firm's interest-bearing debt along with long-term and short-term liabilities the total of which is divided by the total capital. It is important to note that this figure must strictly be calculated from interest-bearing loans meaning equities do not qualify.

Southwest's Total Debt to Total Assets is 14.09. This ratio is also an indicator of a firm's financial leverage that shows the percentage of company assets that were financed through debt, liabilities, and creditors. The figure indicated above was arrived at by dividing Southwest's total liabilities by its total assets.

The next ratio on Southwest's capital structure is a variation of the D/E ratio that focuses strictly on what a firm borrows to be repaid in the long-run. The current Long-Term Debt to Equity ratio stands at 31.83, which is arrived at by calculating the long-term debt over the company's common equity at book value. It is important to note that common equity must be calculated at book value for this ratio. Ultimately, higher long-term debt to equity ratios implies that a firm has more leverage.

Finally, Southwest's Long-Term Debt to Total Capital ratio stands at 23.55 a figure arrived at by calculating the fraction of debt to be repaid in the long-run over the total capital, which includes company stock as well.

Cost of Capital

Every investment requires a certain amount of capital to actualize. Likewise, firms make a resolution to abandon certain potential investments and settle for one, which is deemed most practical. Therefore, the opportunity cost of making certain investments is referred to as the 'cost of capital.' Essentially, cost of capital is the rate of return that could potentially have been accrued if the same money was put in another venture with equal risk. Southwest Airlines' weighted average cost of capital currently stands at 9.41% while the ROIC is estimated at 41.09%. It is evident that the company is making higher returns on investment in comparison to the costs incurred to raise the amount of capital needed for that particular investment. The airline is earning returns in the tune of excess. With a cost of capital approaching 10 percent, Southeast is likely to continue making more returns on new investments moving into the next quarter. The company value will increase as it keeps powering more growth.

While calculating the weighted average cost of capital (WACC) the goal is to determine, on average, the rate at which a firm is expected to pay the holders of security to finance the assets. Since firm assets are financed through equity and debt, the cost of capital becomes the cost average of debt and equity. Calculating the weighted average enables a firm to know the amount of interest it will pay for every dollar it finances.

Ratio Analysis

Dividend Policy

Dividend payouts are part of the routine running of business where firms allocate retained earnings in the form of payment to shareholders. Southwest Airlines has a comprehensive dividend policy in which the payouts to shareholders are paid proportionately to the number of shares held. Equally, the payment of dividends, according to the company policy, is also growth-specific. The company also operates by issuing small but consistent dividends similar to those offered by growth companies (utilities). Southwest Airlines declared $.075 per share in the 158th consecutive quarterly dividend in the close of business on March 2016, according to sources retrieved from the company annals. Presently, the company is yet to review its dividend policy amid soaring share price as witnessed at the close of business in the March 2018 quarterly analysis. The dividend payout is yet to fly amid the rising share price, and the company is said to be reviewing the payouts given the consistent and sustainable profitability. With a low-cost business model, the firm's present yields can facilitate an increase in dividend payout.

Currently, the company has a yield of 0.8% along with a $.125 quarterly dividend per share and a payout ratio of 13 percent.

Over the past five years, Southwest has had an impressive dividend payout history; in 2012, the payout doubled, which quadrupled the following year and has made impressive increases between 2014 to date as illustrated in the figure below. Looking at the airline industry in which the firm operates, it is evident that Southwest has a more impressive dividend policy compared to Delta and American Airlines both of whom have higher yields yet they lack sound dividend policies. JetBlue also does not pay dividends either. Therefore, compared to these other key players in the airline industry, Southwest is seen to have a more impressive dividend policy, which has been in place for decades. Part of the company's dividend policy is to ensure it remains committed to sustaining its steady but progressive payout to shareholders.