Page 8 - FINAL CFA II SLIDES JUNE 2019 DAY 6

Equivalent Annual Annuity (EAA) Approach READING 20: CAPITAL BUDGETING
Finds the sequence of equal payments with a PV = project’s NPV.

MODULE 20.2: EVALUATION OF PROJECTS AND DISCOUNT RATE ESTIMATION
EXAMPLE: EAA approach: Evaluate the prior offset printer and
the book press using the EAA approach.

Step 1: Find each project’s NPV: Step 2: Find EAA Step 3: Select greatest EAA
NPV press = $3,245 EAA press : PV = –3,245; FV = 0; N = 6; I = 12; Printer once again!
NPV printer = $2,577 compute PMT = $789
Reinforces the LCML method, but you must
EAA printer : PV = –2,577; FV = 0; N = 3; I = 12; know both!
compute PMT = $1,073

CAPITAL RATIONING – 2 TYPES, HARD AND SOFT:
The allocation of a fixed amount of capital among available projects that will maximize shareholder wealth. Hard occurs when the funds allocated cannot
be increased; Soft occurs when managers can increase their allocated capital budget if they can justify that extra shareholder value can be created);

EXAMPLE: Capital rationing (1) Mayco has a $2,000 capital budget EXAMPLE: Capital rationing (2): And now, which must Mayco undertake?
and can invest in 5 projects as below: Which must Mayco
undertake?

F (requires $1200) has highest NPV ($500) and can go with H (requires $800,
not G with better NPV as we would blow up the capital budget); F and H feasible
Take projects with highest NPV subject to not exceeding $2000: at combined NPV of $800.
A, B, C, and D are all profitable but would cost $2,050! But we could do G, H, J (combined capital of $2000 ($1000 + $800 + $200)) and
get to combined NPV of $930 ($480 + $300 + $150); So we choose G, H, J!
Best 3 are: A, B, and C (total NPV = $580) and a total outlay of
$1,700 (Balance $300 deployed elsewhere in the company) The goal is to maximize the overall NPV within the capital budget, not necessarily
to select the individual projects with the highest NPV.