Question

North Airline Company is considering expanding its territory. The company has the opportunity to purchase one of two different used airplanes. The first airplane is expected to cost $12,000,000; it will enable the company to increase its annual cash inflow by $4,000,000 per year. The plane is expected to have a useful life of five years and no salvage value. The second plane costs $24,000,000; it will enable the company to increase annual cash flow by $6,000,000 per year. This plane has an eight-year useful life and a zero salvage value. Required:
Determine the payback period for each investment alternative and identify the alternative North should accept if the decision is based on the payback approach.

Answer 1

Answer:

1st Airplane

Payback period is 3 years

2nd Airplane

Payback period is 4 years

Explanation:

Payback period is the time period in which initial investment of the asset recovered from it benefit. Annual cash flow is used to calculate the payback period.  

Formula for Payback

Payback Period = Cost of Asset / Annual Cash Inflow

1st Airplane:                

As per given Data

Cost of Airplane = $12,000,000

Cash Flows = $4,000,000

Placing values in the formula

Payback Period = $12,000,000 / $4,000,000

Payback Period = 3 years

2nd Airplane:

As per given Data

Cost of Airplane = $24,000,000

Cash Flows = $6,000,000

Placing values in the formula

Payback Period = $24,000,000 / $6,000,000

Payback Period = 4 years

Answer 2

Answer:

First Airplane Payback Period = 3 years

Second Airplane Payback Period = 4 years

Since, First Airplane is going to repay the Original Cost of the Airplane in shorter amount of time as compared to Second Airplane. Therefore, if the the decision is based on the payback approach the North should accept First Airplane.

Explanation:

NORTH AIRLINE COMPANY

First Airplane:                

Payback Period = Original Cost of the Asset / Annual Cash Inflow

Payback Period = $12,000,000 / $4,000,000

Payback Period = 3 years

Second Airplane:

Payback Period = Original Cost of the Asset / Annual Cash Inflow

Payback Period = $24,000,000 / $6,000,000

Payback Period = 4 years