Topic : Capital budgeting Techniques

Discussion Question:

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:

Project Initial investment Cash flow year 1 Cash flow year 2 NPV

(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)

Project Initial investment Cash flow year 1 Cash flow year 2 NPV

(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)
Calculate EAA FACTOR of both projects

Equivalent annual annuity factor:

EAA Formula:  (1  i)n /[(1  i)n  1]

Discount rate 12%

Project A

EAA Factor:

 (1 i)n /[(1  i)n  1]

 (1 0.12)2 /[(1  0.12)2  1]

= 4.93 Ans

Project B

EAA Factor:

=(1 + i)n / [(1+ i)n -1]

=(1 + 0.12)2 / [(1+ 0.12)2 -1]

 (1 i)n /[(1  i)n  1]

 (1 0.12)2 /[(1  0.12)2  1]

= 4.93 Ans

Calculate NPV of both projects by EAA Approach

Equivalent annual annuity

Formula: EAA = Simple NPV * EAA Factor

Project A:
EAA = Simple NPV * EAA Factor

= 392857 * 4.93 = 1936785 Ans

Project B:

EAA = Simple NPV * EAA Factor

= 690051* 4.93 = 3401951 Ans

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?

Project B is better than project A because of high value.

Yes CLA and EAA methods both have same because in both methods we have selected the high
values.