ABC Telecom has to choose between two mutually exclusive projects. If it chooses
ID: 2740226 • Letter: A
Question
ABC Telecom has to choose between two mutually exclusive projects. If it chooses project A, ABC Telecom will have the opportunity to make a similar investment in three years. However, if it chooses project B, it will not have the opportunity to make a second investment. The following table lists the cash flows for these projects. If the firm uses the replacement chain (common life) approach, what will be the difference between the net present value (NPV) of project A and project B, assuming that both projects have a weighted average cost of capital of 12%? $10, 906 $19, 994 $13, 632 $18, 176 $16, 358 ABC Telecom is considering a three-year project that has a weighted average cost of capital of 10% and a NPV of $85, 647. ABC Telecom can replicate this project indefinitely. What is the equivalent annual annuity (EAA) for this project? $36, 162 $34, 440 $37, 884 $30, 996 $43, 050Explanation / Answer
Replacement chain (common life) approach involves finding the NPV of Project B over a 6 year period, and then comparing this extended NPV with the NPV of Project A over the same 6 years. Project A Project B PV @ 12% Present value of Project A Present value of Project B Year 0 -$10,000 -$10,000 -$45,000 1.0000 -$10,000 -$45,000 1 $7,000 $7,000 $10,000 0.8929 $6,250 $8,928.57 2 $15,000 $15,000 $17,000 0.7972 $11,957.91 $13,552.3 3 $14,000 $4,000 $16,000 0.7118 $2,847.12 $11,388.48 4 $7,000 $15,000 0.6355 $4,448.63 $9,532.77 5 $15,000 $14,000 0.5674 $8,511.4 $7,943.98 6 $14,000 $13,000 0.5066 $7,092.84 $6,586.2 NPV $31,107.89 $12,932.3 Difference $18,175.59 a) $18,176 b) EAA Cost of capital (rate) 10.00% Nper 3 NPV (PV) $85,647 EAA(PMT) $34,439.93 EAA(PMT) $34,440