Question

P8-32 (similar to) Question Help You are trying to decide between two mobile phone carriers. Carrier A requires you to pay $190 for the phone and then monthly charges of $60 for 24 months. Carrier B wants you to pay $85 for the phone and monthly charges of $66 for 12 months. Assume you will keep replacing the phone after your contract expires. Your cost of capital is 3.6%. Based on cost alone, which carrier should you choose?

Answer 1

Note: We cannot use NPV.

This is a case of comparing projects with different lives.So, use EAA .

For Carrier A:

NPV(A) = PV of Cash Inflows - PV of Cash Outflows

= [{-$60 / (0.036/12)} x {1 - (1 + 0.036/12)^-24}] - $190

= [-$20,000 x 0.0694] - $190 = -$1,387.38 - $190 = -$1,577.38

EAA(A) = NPV / [{1 - (1 + r)^-n} / r]

= -$1,577.38 / [{1 - (1 + 0.036/12)^-24} / (0.036 / 12)]

= -$1,577.38 / 23.1229 = -$68.22

For Carrier B:

NPV(B) = PV of Cash Inflows - PV of Cash Outflows

= [{-$66 / (0.036/12)} x {1 - (1 + 0.036/12)^-12}] - $85

= [-$22,000 x 0.0353] - $85 = -$776.77 - $85 = -$861.77

EAA(A) = NPV / [{1 - (1 + r)^-n} / r]

= -$861.77 / [{1 - (1 + 0.036/12)^-12} / (0.036 / 12)]

= -$861.77 / 11.7692 = -$73.22

As the EAA for Carrier A is less, so, we would choose Carrier A.