Ace, Inc. is considering Project A and Project B, which are two mutually exclusive projects with unequal lives
Project A is an eight-year project that has an initial outlay or cost of $18,000. Its future cash inflows for years 1 through 8 are the same at $3,800. Project B is a six-year project that has an initial outlay or cost of $16,000. Its future cash inflows for years 1 through 6 are the same at $3,600. Ace uses the equivalent annual annuity (EAA) method and has a discount rate of 11.50%. Which, if any, project will Ace accept?
What will be an ideal response?
Answer: We will compute the EAA for both projects and choose the one with the greater positive EAA. If both EAAs are negative, we will then reject both projects. If one Project has a negative NPV (and thus negative EAA), we will then choose the project with the positive NPV (and thus positive EAA). For Project A, the NPV = -CF0 + . Inserting the given values, we have: NPV = -$18,000 + = -$18,000 + ($3,800 × 5.055637)
= -$18,000 + $19,211.42 = $1,211.42. The EAA is the NPV divided by the PVIFA.
We have: EAA (Project A) = = $239.62.
For Project B, the NPV = -CF0 + = -$16,000 +
= -$16,000 + ($3,600 × 4.170294) = -$16,000 + $15,013.06 = -$986.94. The EAA is the NPV divided by the PVIFA. We have: EAA (Project A) = = -$236.66. Ace will take Project A not only because its EAA is positive and superior to Project B's, but because the NPV for Project B is negative. Thus, we can really only consider one project and that is Project A.
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