Question

Mr. S. Berlusconi, the finance manager of Zeffira Company ((ZC), is evaluating two mutually exclusive investment projects, project L and project K. The expected life of project L is six years and that of project K is three years. ZC is planning to replicate investment project K for another three years.   The expected cash inflows and outflows of the projects are provided in the following table:

Project K		Project L
Year	Cash Flow	Year	Cash Flow
0	($25,000)	0	($30,000)
1	20,000	1	25,000
2	20,000	2	25,000
3	20,000	3	25,000
		4	25,000
		5	25,000
		6	25,000

ZC uses a weighted average cost of capital of 12% for both projects.

1. Which project do you advise Mr. Berlusconi to select using NPV, without adjustment for the life of the projects?
2. To adjust for their life difference, you use the replacement chain and the Equivalent Annual Annuity (EAA). Which project do you advise Mr. Berlusconi to pick now?
3. You must explain how you come up with answers in (a) and (b) in writing in 5 lines. Show your work.

Answer 1

	Project K	1.12
	a	b	a*b
Year	Cashflow	PV factor 12% [1/(1+r)]^n	PV
0	(25,000.00)	1.000	(25,000.00)
1	20,000.00	0.893	17,857.14
2	20,000.00	0.797	15,943.88
3	20,000.00	0.712	14,235.60
	Total	2.402	23,036.63
		NPV of project (a)	23,036.63	$
		Total PV factor (b)	2.402
		EAA (a/b)	9,590.60	$

	Project L	1.12
	a	b	a*b
Year	Cashflow	PV factor 12% [1/(1+r)]^n	PV
0	(30,000.00)	1.000	(30,000.00)
1	25,000.00	0.893	22,321.43
2	25,000.00	0.797	19,929.85
3	25,000.00	0.712	17,794.51
4	25,000.00	0.636	15,887.95
5	25,000.00	0.567	14,185.67
6	25,000.00	0.507	12,665.78
	Total	4.111	72,785.18
		NPV of project (a)	72,785.18	$
		Total PV factor (b)	4.111
		EAA (a/b)	17,704.98	$

	Project K	Project L
NPV	23,036.63	72,785.18
EAA	9,590.60	17,704.98
1. Considering NPV, Project L has more NPV. So it should be undertaken
2. Considering EAA, Project L has more annual inflow tha project K, SO project L should be undertaken
More NPV give more value to the company But we have to consider the life of project also. If two projects have different life, then NPV is not suitable. Then we have to find out EAA.
Notes:
EAA = NPV / total pv factor
In total PV factor, 0th year factor will not be considered
NPV = Discounted inflow - Initial investment