Question

Royal 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 $16,200,000; it will enable the company to increase its annual cash inflow by $5,000,000 per year. The plane is expected to have a useful life of five years and no salvage value. The second plane costs $32,400,000; it will enable the company to increase annual cash flow by $7,500,000 per year. This plane has an eight-year useful life and a zero salvage value.

 

Required

1. Determine the payback period for each investment alternative and identify the alternative Gibson should accept if the decision is based on the payback approach. (Round your answers to 1 decimal place)

 

2. Discuss the shortcomings of using the payback method to evaluate investment opportunities.

Answer 1

Requirement 1:

Payback period = cost of investment / Annual cash inflow

PP = $16,200,000 / $5,000,000

PP = 3.24 Years

Payback period = cost of investment / Annual cash inflow

PP = $32,400,000 / $7,500,000

PP = 4.32 Years

 

Alternative 1 should be accepted based on the payback method

Requirement 2:

The payback method does not consider the life of the investment. In this case, Alternative I provides the quicker payback but Alternative 2 continues to provide cash inflows for one year after Alternative I has expired. Also, the payback method does not consider the time value of money.

1. Alternative 1 should be accepted based on the payback method

2. The payback method does not consider the life of the investment. In this case, Alternative I provides the quicker payback but Alternative 2 continues to provide cash inflows for one year after Alternative I has expired. Also, the payback method does not consider the time value of money.