Question

Walker & Campsey wants to invest in a new computer system, and management has narrowed the choice to Systems A and B.

System A requires an up-front cost of $125,000, after which it generates positive after-tax cash flows of $80,000 at the end of each of the next 2 years. The system could be replaced every 2 years, and the cash inflows and outflows would remain the same.

System B also requires an up-front cost of $125,000, after which it would generate positive after-tax cash flows of $60,000 at the end of each of the next 3 years. System B can be replaced every 3 years, but each time the system is replaced, both the cash outflows and cash inflows would increase by 5%.

The company needs a computer system for 6 years, after which the current owners plan to retire and liquidate the firm. The company's cost of capital is 12%. The NPV is 33,392 (rounded to two decimal places).

Using the information from problem 8 on Walker & Campsey, what is the equivalent annual annuity (EAA) for System B? Enter your answer rounded to two decimal places. Do not enter $ or comma in the answer box. For example, if your answer is $12,300.456 then enter as 12300.46 in the answer box.

Answer 1

NPV of system B = 33,392 (given)

an equivalent annual annuity is a method to compare mutually exclusive projects with unequal lives. It gives an annual equal cash flow over the lifespan of project. A project with higher EAA is better,

Formula to calculate EAA,

C = (r x NPV) / (1 - (1 + r)-n )

Where:

C = equivalent annuity cash flow

NPV = net present value

r = interest rate per period

n = number of periods

We are given,

NPV = 33,392

r = 12%

n = 6 years

Putting these values in the formula,

C = (12%*33,392)/(1-(1+.12)^-6) = 4007/(1-.5066) = $8,121.80

Hence the EAA of project B is $8,121.80

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