Fundamentals of Finance

Zeeshan Lecture notes

Equivalent Annual Annuity(EAA)
If we have 2 mutually exclusive projects & the lives of these projects is
different then we must use profitability index or equivalent annual
annuity.

If we have projects with same life period we can decide based on PBP
NPV, IRR etc
But if life of projects is different then we use profitability index &
equivalent annual annuity.
Question example:

Project A
Project B:

Non simple projects:

Example 2: Profitability index / Equivalent annual annuity
both methods: (wrong answers)
Multiple IRRs

Replacement chain method:

So in this case Project A will be selected.
IRR has a bigger figure
market rate is achievable every year
You may not be able to get IRR rate every year
Modified internal rate of return (MIRR)
Example:

All methods discussed till now:

Which method to use?
We want to choose a method that deals with cash, ARR deals with net
profit, and net profit is not accurate, so ARR is not used and similarly
we didn’t learn it in class.
1. Simple payback period is very simple but has disadvantages
 Does not consider tvm and future cash flows
2. Discounted payback period considers tvm but not future cash
flows
3. NPV & IRR are two methods which are superior as they consider
TVM and future cash flow, they answer by how much the value of
business will increase.

NVP or IRR
“NPV is superior” to IRR, as NVP tells by how much value your business
will increase, NVP supposes that future cash flows are being reinvested
at market rate, we can have multiple IRRs, and IRR supposes that future
cash flows are being reinvested at IRR rate, which is not realistic.
Conflict between NPV and IRR:

In some cases, it is possible that NPV and IRR are giving opposite
decisions.
“IMPORTANT “
So if there is ever a conflict, we will go with decision of NPV