Question

North airline company is considering expanding its territory. The company has the opportunity to purchase one of twoDifferent used airplanes. The first airplane is expected to cost $12 million; it will enable the company to increase its annual cash inflow by $4 million per year. The plane is expected to have a useful life of five years and no salvage value. The second plane cost $24 million; it will enable the company to increase annual cash flow by $6 million per year. This plane has an eight year useful life and a zero salvage value.

different used airplanes. The first airplane is expected to cost $12 million; it will enable the company to increase its annual cash inflow by $4 million per year. The plane is expected to have a useful life of five years and no salvage value. The second plane cost $24 million; it will enable the company to increase annual cash flow by $6 million per year. This plane has an eight year useful life and a zero salvage value.

a. determine the payback period for each investment alternative and identify the alternative north should except if the decision is based on the payback approach

b. discuss the shortcomings of using the payback method to evaluate investment opportunities

Exercise 10-12A Determining the payback period North Airline Company is considering expanding its territory. The company has the opportunity purchase one of two different used airplanes. The first airplane is expected to cost $12.000.000it 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 a. Determine the payback period for each investment alternative and identify the alternative North should accept if the decision is based on the payback approach. b. Discuss the shortcomings of using the payback method to evaluate investment opportunities.

Answer 1

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North Airline Company
Answer 10-12 a
Payback period= Cash cost of investment/ Annual cash inflow.
Alternative 1			Alternative 2
Cash cost of investment	12,000,000.00		Cash cost of investment	24,000,000.00
Annual cash inflow.	4,000,000.00		Annual cash inflow.	6,000,000.00
Payback period	3.00		Payback period	4.00
Payback period of Alternative 1 is less.
So based on Payback period North Airline Company should go for Alternative 1.
Discuss the shortcomings of using the cash payback method for evaluating investment opportunities.
It fails to take into account the time value of money (TVM) and adjust the cash inflows accordingly. The TVM is the idea that the value of cash today will be worth more than in the future because of the present day's earning potential.
It fails to consider inflows of cash that occur beyond the payback period, thus failing to compare the overall profitability of one project as compared to another. Since many capital investments provide investment returns over a period of many years, this can be an important consideration.
The simplicity of the payback period analysis falls short in not taking into account the complexity of cash flows that can occur with capital investments. In reality, capital investments are not merely a matter of one large cash outflow followed by steady cash inflows. Additional cash outflows may be required over time, and inflows may fluctuate in accordance with sales and revenues.
This method also does not take into account other factors such as risk, financing or any other considerations that come into play with certain investments.