Skip to main content

What is Equivalent Annual Annuity (EAA)?

 To evaluate the project performance capital budgeting tools are used like internal rate of return (IRR), Average rate of return (ARR), discounted payback period, Net Present Value (NPV) etc. these tools are also used to make a decision to invest in those big projects( which needs huge amount to invest) or not?

These tools are helpful to compare two or more than two projects whose time interval of cash flows are same to know which project is more beneficial for the company.

But these tools are not beneficial to use when the time period of the cash inflow are not same. In that case equivalent annual annuity is used.

Equivalent Annual annuity: It is used when projects are mutually exclusive. The time interval of cash inflows of projects is differ from one another. With the help of it we can find the measure each projects correctly according to their cash flows in given period.

Formula:

EAA = NPV*r / 1-(1+r) ^-n

Where as

EAA = Equivalent Annual Annuity

NPV = Net Present Value

R = rate of return

N = number of years

Example: Suppose Company XYZ wants to invest Rs. 50,000 for that Company have two projects A and B. Both the projects have given 8 % per annum rate of return. Find out which project is good for the company in compare to another. Other information is as follows:

Project A

Project B

15,000

8,000

18,000

12,000

7,000

10,000

 

4,500

 

Solution:

Years

Project A

Project B

Discount rate(0.08)

Present value  of project A

Present Value of project B

 

(50,000)

(50,000)

 

(50,000)

(50,000)

1

15,000

8,000

1.08

13,888.89

7,407.41

2

18,000

12,000

1.1664

15,432.10

10,288.07

3

7,000

10,000

1.259712

5,556.83

7,938.32

4

 

4,500

1.36048896

 

3,307.63

NPV

 

 

 

-15,122.19

-21,058.57

EAA = NPV*r / 1-(1+r) ^-n

Project A:

= -15,122.19*0.08 / 1-(1+0.08) ^-3

=   -1,209.7752 / 1-(1/1.259712)

=   -1,209.7752 / 1 – 0.793832241

= -1,209.7752/0.206167759

= Rs. -5867.92

Project B:

= -21,058.57*0.08 / 1-(1+0.08) ^-4

= -1, 684.6856/ 1-(1/1.36048896)

= -1,684.6856/ 1 – 0.735029853

= -1,684.6856/0.264970147

= Rs. -6358.02

Project A is better option in comparison to project B.

Example: Find out which project is more beneficial for the company and the rate of return is 10% and further information is given below:

Project P

Project Q

(1,00,000)

(1,00,000)

30,000

30,000

34,000

25,000

28,000

23,000

 

19,000

 

Solution:

Years

Project P

Project Q

Discount rate

Present value of project P

Present value of project Q

0

(1,00,000)

(1,00,000)

10%

(1,00,000)

(1,00,000)

1

30,000

30,000

1.1

27,272.73

27,272.73

2

34,000

25,000

1.21

28,099.17

20,661.16

3

28,000

23,000

1.331

21,036.81

17,280.24

4

20,000

19,000

1.4641

13,660.27

12,977.26

5

 

15,000

1.61051

 

9,313.82

Total

 

 

 

90,068.98

87,505.21

 

NPV of project P= Present Value of Cash inflows – Initial investment

= 90,068.98 – 1, 00,000

= Rs. -9,931.02

NPV of project Q = Present value of cash inflows – Initial investment

= 87,505.21 -1, 00,000

= Rs. – 12,494.79

EAA of project P = -9,931.02*0.10 / 1-(1+0.10) ^-4

= -993.102/1-(1/1.4641)

= -993.102 / 1- 0.683013455

= -993.102 / 0.316986545

= Rs.-3,132.95

EAA of project Q = -12,494.79*0.10 / 1-(1+0.10) ^-5

= -1,249.479/1-(1/1.61051)

= -1,249.479 / 1- 0.620921323

= -1,249.479 / 0.379078677

= Rs.-3,296.09

Project P is better than Project Q

 

Comments

Post a Comment

Popular posts from this blog

How to calculate Cost of Preference Share Capital?

Cost of Preference Share Capital:  An amount paid by company as dividend to preference shareholder is known as Cost of Preference Share Capital. Preference share is a small unit of a company’s capital which bears fixed rate of dividend and holder of it gets dividend when company earn profit. Dividend payable is not a tax deductible amount. So, there is no tax adjustments required for comparing with cost of debt. Formula for Cost of Preference Share: Irredeemable Preference Share Redeemable Preference Share K p  = Dp/NP K p  = D p +((RV-NP)/n )/ (RV+NP)/2 Where, K p  = Cost of Preference Share D p  = Dividend on preference share NP = Net proceeds from issue of preference share (Issue price – Flotation cost) RV = Redemption Value N = Period of preference share Example:  A company issues 20,000 irredeemable preference share at 8% whose face value is Rs.50 each at 4% discount. Find out the Cost of Preference Share Capital.
88 comments
Read more

What is the difference between Cheque book and Pass book?

 Cheque book is issued by bank in customers / account holder request. With the help of this book account holder can withdraw cash from his/her account. Bank does not charge any fee to issued cheque book to its customer. But afterward bank charges some amount for using bank facility like cheque book, Debit card etc.So, Automatic some definite amount deducted from customer bank account. Pass book is  also issued by bank to its customer. It helps to record all the bank related activity according to date that is withdrawal and deposit. It is recorded by bank but the book is kept by customer to know the current balance of  his /her account.  Point of difference Pass book Cheque book What is the meaning of pass book and cheque book? Passbook is a book in which all withdrawal and deposit against customer account is recorded.   Cheque book is a book of cheques which are used to withdrawal the money to bank account.
Post a Comment
Read more

How to calculate interest on Hire Purchase System?

Interest on hire purchase:  Interest is calculated on Cash value of goods not in instalment value which includes cash value of goods and interest amount. It is calculated on yearly, quarterly and yearly basis. Interest is not calculated on down payment which is paid at delivery of goods. Depreciation is also charged on the hire purchase goods at the end of financial year. The method applies for depreciation is based on the contract between the parties.   Example:  Company V purchased a machine of Rs.70, 000 and paid Rs.5, 000 as down payment. The interest charged @6% and 8% depreciation annually. The instalment value for each year is Rs. 10,000. Find out the interest amount for 5 years. Solution: Interest calculated on Rs. Interest Instalment Cash Value 65, 000 65, 000*0.06 = 3, 900 12, 500 8, 600 56, 400 56, 400*0.06 = 3, 384 12, 500 9, 116 47, 284 47, 284*0.06 = 2, 837 12, 500 9, 6
3 comments
Read more