Question

Vanderheiden Inc. (Q2) is considering two average-risk alternative ways of producing its patented polo shirts.  Process S has a cost of $8,000 and will produce net cash flows of $5,000 per year for 2 years.  Process L will cost $11,500 and will produce cash flows of $4,000 per year for 4 years.  The company has a contract that requires it to produce the shirts for 4 years, but the patent will expire after 4 years, so the shirts will not be produced after 4 years. Inflation is expected to be zero during the next 4 years.  If cash inflows occur at the end of each year, and if Vanderheiden's cost of capital is 10 percent, what is the annual payment received from each project under the equivalent annual annuity approach?

how I do calculate process S present value and process L present value? Then, I can follow pv to calculate PMT

Answer 1

Solution :

In equivalent annual annuity approach we need to find the NPV first then using the formula for annual equivalent equity we can find the annuity, here project cash flows are treated as an annuity

Equivalent annual equity = Net present value / [ (1 - (1+ discount rate)^-life of the project)/Discount rate ]

Calculations are done on the excel sheet

Calculate the NPV then PMT

PMT for Project S : 392.47

PMT for Project L: 372.09