Question

Southwest Airlines provides scheduled air transportation services in the United States. Like many airlines, South-west leases many of its planes from Boeing Company. In its long-term debt disclosure note included in the financial statements for the year ended December 31, 2015, the company listed $324 million in lease obligations. The existing leases had an approximate ten-year remaining life and future lease payments average approximately $45 million per year.

Required:

1. Determine the effective interest rate the company used to determine the lease liability assuming that lease payments are made at the end of each fiscal year.

2. Repeat requirement 1 assuming that lease payments are made at the beginning of each fiscal year. 

Answer 1

1)

Year	Cash outflows Per year	Present value factor at interest rate 5%	Present value at interest rate 5%	Present value factor at interest rate 8%	Present value at interest rate 8%
1-10	45	7.7217	347.4765	6.7101	301.9545

Interest Rate of company

= Lower interest rate

    +[{(Present value at lower interest rate-Lease obligations)/(Present value at lower interest rate- Present value at higher interest rate)} *Difference between two rates]

= 5 +[{(347.4765-324)/(347.4765-301.9545)} * 3

= 5 +{(23.4765/45.522) *3}

= 5 +1.55

= 6.55%

2)

Year	Cash outflows Per year	Present value factor at interest rate 5%	Present value at interest rate 5%	Present value factor at interest rate 9%	Present value at interest rate 9%
0-9	45	8.1078	364.851	6.9953	314.7885

Interest Rate of company

= Lower interest rate

    +[{(Present value at lower interest rate-Lease obligations)/(Present value at lower interest rate- Present value at higher interest rate)} *Difference between two rates]

= 5 +[{(364.851-324)/(364.851-314.7885)} * 4

= 5 +{(40.851/50.0625) *4}

= 5 +3.26

= 8.26%