Corcoran Consulting is deciding which of two computer systems topurchase. They c

Question

Corcoran Consulting is deciding which of two computer systems topurchase. They can purchase state-of-the-art equipment (System A)for $20,000, which will generate cash flows of $6,000 at the end ofeach of the next 6 years. Alternatively, they can spend $12,000 forequipment that can be used for 3 years and generates cash flows of$6,000 at the end of each year (System B). if the company’sWACC is 10 percent and both “projects” can be repeatedindefinitely, which system should be chosen and what is itsEAA?

Explanation / Answer

System A

System B

Equivalent Annual Annuity (EAA)

         Thismethod finds the annual annuity that is equivalent to the NPV. Wewould calculate the EAA for all the projects and choose the projectwith the largest EAA..

          Here System A has the Largest EAA. Thus, System Ais better.

System A

System B

Cost                                                $20,000 Cost                                     $12,000 AnnualCashflows                               $6,000 Annual Cashflows                  $6,000 Number ofYears                              6 Years Number ofYears                    3Years Weighted Average Cost of Capital (WACC)10% Calculating NPV: Calculating NPV: NPV = $6,000(PVoAF6,10%) - $20,000 NPV = $6,000 (PVoAF3,10%) - $12,000 NPV = $6,000(4.3553) - $20,000 NPV = $6,000 (2.4869) - $12,000 NPV = $6,131.80 NPV = $2,921.40 Calculating Equivalent Annual Annuity(EAA): EAA = NPV / Annual AnnuityFactor EAA = $6,131.80 / 4.3553 EAA = $2,921.40 / 2.4869 EAA = $1,407.89 EAA = $1,174.71

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