Reading 21: Equivalent Annual Annuity Approach

CFA Level II Corporate Finance
#1

Hello All,

I have come to a point of confusion in my studies relating to the equivalent annual annuity approach to evaluating mutually exclusive capital budgeting project with different useful lives. According to schweser’s professor note on page 165 (study session 7 - corporate finance, reading 21 - capital budgeting) “either of the two methods (least common multiple of lives method & Equivalent Annual Annuity method) will lead to the same conclusion” - it is my impression that this statement has is partially incorrect. To me, it appears that the two methods will certainly come to the same conclusion if the discount rates of the two projects are equivalents, but that the two methods may yield different conclusions in the event that the discount rates between the projects differ. Consider the following: ceteris paribus, the annual payment derived from equivalent annual annuiity method will increase as the discount rate of a project increases whereas the NPV derived from the least common multiple of lives method will decrease as the discount rate of the project increases. Therefore, in the event that two mutually exclusive projects have different discount rates, the Least common multiple of lives method would be superior to the equivalent annual annuity approach.

Am I correct?

Best,

Analyzer

#2

You had me at “Ceteris Paribus”

smiley

The whole essence of the EAA and the LCM method is to put the two projects on an equal time scale and thus eliminate that particular distortion which otherwise would make the projects uncomparable.

#3

Thanks for your expedited reply. Thankfully, I do understand that, but I still don’t think that my question has been answered - might the analyses come up with different conclusions in the event that the discount rates between the projects differ? In that case, isn’t the least common multiples method more reliable?

#4

Huh, I’d never looked at it that way before. Wonder if someone could clear that up.

#5

If the risk profiles of the two projects are different, you would need to use differing cash flows. How ever even after using that, to make the two comparable, you put them on an equivalent time scale or as the EAA proposes you compute which provides the better annuity. More is better.