Suppose you are working in the finance department of a well-reputed organization.

Management of
the organization has given you two alternate projects and assigned you a task to select a short-term
project on the basis of Net Present Value (NPV). The life span of both projects is different which
causes the problem for accurate selection of a project. It is the norm of the industry if the projects
have different life span; there are two standard methods to equate them at one point of time. First is
the Common Life Approach (CLA); second is Equivalent Annual Annuity Approach (EAA) as
both provide better result in case of uneven lives of projects under consideration.
Following information has been provided about two projects by the management:

Initial investment Cash flow year 1 Cash flow year 2 NPV

Project
(Rs) (Rs) (Rs) (Rs)

A 500,000 1,000,000 - 392,857

B 1,000,000 1,000,000 1,000,000 690,051

NPV under Common Life Approach (CLA)

NPV
Initial investment Cash flow year 1 Cash flow year 2
Project
(Rs)
(Rs) (Rs)

A 500,000 1,000,000 - 743,622.5

B 1,000,000 1,000,000 1,000,000 690,050.9

Requirements:
You are advised to calculate NPV by EAA method if discount rate is 12% and suggest best one to
the management along with the solid reason.
1. Calculate EAA FACTOR of both projects.
2. Calculate NPV of both projects by EAA Approach.
3. Based on the calculations, which project you will suggest and why? Do CLA and EAA
methods have led to same decision about the selection of project? (Your selection should be
supported with logical reasoning)
1. EAA FACTOR =(1+i)/ [(1+i)n-1]
Where n=life of project & i =discount rate
Project A’s EAA Factor =(1+i)n/ [(1+i)n-1]
=(1+0.12)1/[(1+0.12)1-1]
 = 9.33
Project B’s EAA Factor =(1+i)n/[(1+i)n-1]
=(1+0.12)2/[(1+0.12)2-1]
= 4.93

2. Equivalent Annual Annuity

Formula: EAA=Simple NPV *EAA Factor

Project A’s EAA = Simple NPV *EAA Factor

=392857*9.33
= 3665355.81

Project B’s EAA = Simple NPV *EAA Factor

=690050*4.93
= 3401946.5
Conclusion : Project A is better
3. NPV or Project A= -500000 +(1000000-500000)/1.12 + 1000000/(1.12)2
= -500000 +446428.57 + 797193.88= 743622.45
NPV for Project B= -1000000 +(1000000/1.12) + 1000000/(1.12)2
= -1000000 + 892857.14 + 797193.88= 690051.02
Project A is better

ClA and EAA methods led to same decision only the number for EAA and NPV are different