Question

Your firm is considering two projects. Your boss asked you to use the Equivalent Annual Annuity method. Project A has an expected life of seven years, will cost $50,000,000, and will produce net cash flows of $12,000,000 each year. Project B has a life of fourteen years, will cost $60,000,000, and will produce net cash flows of $10,000,000 each year. The firm’s cost of capital is 12%. What is the equivalent annual annuity for each project? Which project should the firm accept? Show your full work.

CAN YOU SHOW STEPS

Answer 1

NPV = Present value of cash inflows - Presnet value of cash outflows

Equivalent Annual Annuity = NPV/Present value Annuity factor

Project A, NPV = -50,000,000 + 12,000,000*PVAF(12%, 7 years)

= -50,000,000 + 12,000,000*4.5638

= $4,765,600

EAA = 4,756,600/4.5638 = $1,044,217.54

Project B. NPV = -60,000,000 +10,000,000*PVAF(12%, 14 years)

= -60,000,000 + 10,000,000*6.6282

= $6,282,000

EAA = 6,282,000/6.6282

= $947,768.62

Hence, project A is better since higher EAA