Creative Furniture is considering two mutually exclusive projects that would automate part of its production facilities. Project A costs $120,000 and would produce net cash flows of $37,000 annually for 5 years. Project B also costs $120,000 and will produce annual net cash flows of $25,000 for 10 years. Creative's cost of capital is 11%. Assume that in 5 years, Project A will still cost $120,000 and produce 5 more years of $37,000 annual net cash flows. Using the equivalent annual annuity method, which project should be chosen?

Question

Quizplus · Accepted Answer

The equivalent annual annuity (EAA) method converts the net present value (NPV) of projects into an annualized cash flow, making it easier to compare projects with different lifespans. For Project A, the NPV can be calculated for the first 5 years and then adjusted to reflect the option to replicate the project for another 5 years at the same cost and cash flows, effectively making it a 10-year project for comparison purposes. For Project B, the NPV is calculated over its 10-year lifespan. The project with the higher EAA should be chosen. Given the information, Project B's higher NPV when adjusted to an annual figure suggests it provides more value, but without specific NPV calculations provided in the choices, the correct answer hinges on understanding that the EAA method aims to identify the project that maximizes value over time, and the choice provided mistakenly indicates Project B as superior without aligning with the method's correct application or outcome based on the given data. However, the correct approach would involve calculating the NPV for both projects, adjusting for the repeat investment in Project A, and then converting these NPVs into EAAs for accurate comparison. The choice provided suggests a misunderstanding or misapplication of the EAA method's outcome.

Creative Furniture Is Considering Two Mutually Exclusive Projects That Would