Question

Kermit Kite Co. has 2 Projects under consideration- PROJECT C and PROJECT D with the following cashflows.

PROJECT C PROJECT D

Year 0 (800,000) Year 0 (360,000)

Year 1 450,000    Year 1 200,000

Year 2 350,000    Year 2 265,000

Year 3 215,000

The firm's cost of capital is 12%.

Calculate the EAA for each project. Which is the preferred project under EAA and why?

Answer 1

NPV of project C is computed as follows:

= Initial investment + Present value of future cash flows

Present value is computed as follows:

= Future value / (1 + r)ⁿ

So, the NPV is computed as follows:

= - 800,000 + 450,000 / 1.12 + 350,000 / 1.12² + 215,000 / 1.12³

= 33,836.32471

Present value annuity factor of 12% of 3 years is computed as follows:

= [ (1 – 1 / (1 + r)ⁿ) / r ]

= [ (1 - 1 / (1 + 0.12)³ ) / 0.12 ]

= 2.401831268

So, the EAA will be as follows:

= 33,836.32471 / 2.401831268

= 14,087.7193

NPV of project D is computed as follows:

= Initial investment + Present value of future cash flows

Present value is computed as follows:

= Future value / (1 + r)ⁿ

So, the NPV is computed as follows:

= - 360,000 + 200,000 / 1.12 + 265,000 / 1.12²

= 29,827.80612

Present value annuity factor of 12% of 2 years is computed as follows:

= [ (1 – 1 / (1 + r)ⁿ) / r ]

= [ (1 - 1 / (1 + 0.12)² ) / 0.12 ]

= 1.69005102

So, the EAA will be as follows:

= 29,827.80612 / 1.69005102

= 17,649.0566

Since the EAA of project D is greater than the EAA of project C, hence Project D shall be selected.

Whenever there are projects having indifferent lives, we shall compute the EAA of both of the projects and the project which have greater EAA shall be selected.

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