How would you evaluate the comments by Simpson’s supervisor about not using the IRR and about using the EAA? The supervisor is:

Barbara Simpson is a sell-side analyst with Smith Riccardi Securities. Simpson covers the
pharmaceutical industry. One of the companies she follows, Bayonne Pharma, is evaluating a
regional distribution center. The financial predictions for the project are as follows:

Fixed capital outlay is h1.50 billion.

Investment in net working capital is h0.40 billion.

Straight-line depreciation is over a six-year period with zero salvage value.

Project life is 12 years.

Additional annual revenues are h0.10 billion.

Annual cash operating expenses are reduced by h0.25 billion.

The capital equipment is sold for h0.50 billion in 12 years.

Tax rate is 40 percent.

Required rate of return is 12 percent.
24 Learning Outcomes, Summary Overview, and Problems
part-i-02 13 January 2012; 10:13:23
Simpson is evaluating this investment to see whether it has the potential to affect
Bayonne Pharma’s stock price. Simpson estimates the NPV of the project to be h0.41 billion,
which should increase the value of the company.
Simpson is evaluating the effects of other changes to her capital budgeting assumptions.
She wants to know the effect of a switch from straight-line to accelerated depreciation on the
company’s operating income and the project’s NPV. She also believes that the initial outlay
might be much smaller than initially assumed. Specifically, she thinks the outlay for fixed
capital might be h0.24 billion lower, with no change in salvage value.
When reviewing her work, Simpson’s supervisor provides the following comments.
“I note that you are relying heavily on the NPV approach to valuing the investment decision.
I don’t think you should use an IRR because of the multiple IRR problem that is likely to
arise with the Bayonne Pharma project. However, the equivalent annual annuity would be
a more appropriate measure to use for the project than the NPV. I suggest that you compute
an EAA.”
A. incorrect about both.
B. correct about IRR and incorrect about EAA.
C. incorrect about IRR and correct about EAA.

Answer: A. incorrect about both.