North Airline Company is considering expanding its territory. The company has th

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.

Explanation / Answer

First airplane:-

Payback period = Cost of first airplane ÷ Annual cash inflow = 12,000,000÷4,000,000 = 3 years

Second airplane:-

Payback period = Cost of second airplane ÷ Annual cash inflow = 24,000,000÷6,000,000 = 4 years

If the decision is based on payback period, then the investment with minimum payback period should be selected. Therefore, investment on first airplane should be selected, because it's payback period is 3 years as compared to second airplane whose payback period is 4 years.

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