Zellars, Inc. is considering two mutually exclusive projects, A and B. Project A

Question

Zellars, Inc. is considering two mutually exclusive projects, A and B. Project A costs $75,000 and is expected to generate $48,000 in year one and $45,000 in year two. Project B costs $80,000 and is expected to generate $34,000 in year one, $37,000 in year two, $26,000 in year three, and $25,000 in year four. Zellars, Inc.'s required rate of return for these projects is 10%.

Project A: NPV=$5,826, Profitability Index=1.08, Internal Rate of Return= 15.81%

Project B: NPV=$18,097, Profitability Index=1.23, Internal Rate of Return= 20.79%

Question 1) Using the above information, which project would you recommend using the replacement chain method to evaluate the projects with different lives?
a. Project B because its life is longer than Project A.
b. Project A because its replacement chain NPV is $21,652, which exceeds the NPV for Project B.
c. Project A because its replacement chain NPV is $15,642, which exceeds the NPV for Project B.
d. Project B because the replacement chain NPV for Project A is only $10,642.

Question 2) Using the above information, the equivalent annual annuity amount for project A is ________.
a. $2,889
b. $3,357
c. $4,485
d. $5,532

Question 3) Using the above information, the equivalent annual annuity amount for project B is ________.
a. $3,875
b. $4,994
c. $5,709
d. $6,851

If you can, please show the formula for the equivalent annual annuity amount. Thank you in advance.

Explanation / Answer

Calculation of Equivalent Annual Annuity (EAA) flows for Projects

Therefore answer to Question 2 is b. $3,357

and answer to Question 3 is c. $5,709

Selection of project based on replacement chain method

Project B has 4 years of life an Project A has 2 years of life.

To make the life of Project A eaqual to Project B, same project A shall be taken up for next 2 years for evaluation as under:

NPV of adjusted Project A= $10,635 (approx.) 0r $10,642

Please note the diffence is due to rounding off.

NPV of Project B= $18,097

On the basis of NPV Project B should be selected

IRR of B is more than project A i.e. 20.79%

P.I. of Project A = PV Inflows/ PV of outflows

= $1,47,585/$131,325 = 1.12 < P.I. of Project B = 1.23

Thus, as per all the three test Project B should be selected.

Answer to Question 1 is d. Project B because the replacement chain NPV for Project A is only $10,642.

Particulars Project A Project B NPV (i) $5,826 $18,097 Life 2 years 4 Years PVAF @ 10% for respective life period (ii) 1.736 3.170 EAC (i/ii) $3357 $5709

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