Question

A company's weighted average cost of capital is 11% per year. A project requires an investment cost of $4,800 today and it is expected to generate free cash flows of $2,000 per year for the next five years. What is the project's equivalent annual annuity (EAA)? OA) $721.9 B) $718.1 C) $710.3 OD) $719.0 E) $720.3

Answer 1

Equivalent annual annuity (EAA) is used to evaluate mutually exclusive projects whose lives are not equal. It basically helps find equal annual payments over the period of the project whose NPV is equal to the NPV of the project.

The formula for EAA is given as under:

EAA = r*NPV/{1-(1+r)^(-n)}

where r is the weighted average cost of capital,

NPV is the net present value

n is the number of periods

$2000 is the cash inflow expected each year for 5 years.

Calculate the npv of the project as under:

NPV = -4800+2000/(1.11) + 2000/(1.11^2) + 2000/(1.11^3) + 2000/(1.11^4) + 2000/(1.1^5)

NPV = $2591.79

Thus, EAA = 0.11*2591.79/{1-(1.11^(-5))}

EAA = $701.26

Excel can also be used to find this as under:

A B с D E F G 1 2 0 4 5 2 3 4 Year 5 Cash flow 6 NPV 7 EAA 8 1 2000 2 2000 3 2000 2000 2000 -4800 2591.79 -701.26

A B С DE F G 1 N 3 4 Year 0 1 2 3 4 5 5 Cash flow -4800 2000 2000 2000 2000 2000 6 NPV =NPV(0.11, C5:65)+B5 7 EAA =PMT(0.11,5,B6) 00

Thus, the equivalent annual annuity is $701.26. None of the given options are correct.

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