In practical life, an enterprise has many options to invest in long term projects. These projects have different life span. For financial analyst to evaluate various projects with unequal lives, the solution is not easy. He cannot compare NPV or IRR of the projects with unequal life to suggest the best possible option. Here the concept of Equivalent Annual Net Present Value comes into focus. It is also called Equivalent annuity cash flow (EAC). The project that yields the highest annual net present value is selected to be undertaken.
Formula
Annual Net Present Value = NPV / Annuity factor
Example
ABC is engaged in the publishing of books for different level of classes. It is considering investing in either one of the two under consideration projects:
Option 1 – Invest in Project A
Investing in new world class printing set up that will give boost in its production by 35 {1bb28fb76c3d282be6cfd0391ccf1d9529baae691cd895e2d45215811b51644c}. The initial investment requires for this project is $ 200 million. The expected cash flows are $ 300 million per year for the next 06 years.
Option 2 – Invest in Project B
The 2nd option is to acquire the same setup as Project A but the machinery will be of China manufactured. This will require initial investment of $ 500 million and $ 600 million cash inflows for the next 03 years.
Required
You are the financial analyst of ABC. Suggest ABC whether it should go for project A or B. For calculation purpose, consider discount rate equals to 10 {1bb28fb76c3d282be6cfd0391ccf1d9529baae691cd895e2d45215811b51644c}.
Solution
Project 1
| Year | 0 | 1 | 2 | 3 | 4 | 5 | 6 |
| Cash Flow | -500 | 600 | 600 | 600 | 600 | 600 | 600 |
| Discount factor | 1 | 0.9091 | 0.8264 | 0.7513 | 0.6830 | 0.6209 | 0.5645 |
| PV | -500 | 545.46 | 495.84 | 450.78 | 409.8 | 372.54 | 338.7 |
| NPV | $ 2113.12 |
Annuity Factor =4.3553
Equivalent annuity cash flow (EAC) = NPV / Annuity factor = 2113.12 / 4.3553 = $ 485.18
Project 2
| Year | 0 | 1 | 2 | 3 |
| Cash Flow | -500 | 600 | 600 | 600 |
| Discount factor | 1 | 0.9091 | 0.8264 | 0.7513 |
| PV | -500 | 545.46 | 495.84 | 450.78 |
| NPV | $ 992.08 |
Annuity Factor =2.4869
Equivalent annuity cash flow (EAC) = NPV / Annuity factor = 992.08 / 2.4869 = $ 398.92
Conclusion
When we compare EAC of both projects, project A has higher value than that of project B. So, ABC should undertake project A.