Equivalent Annual Cost
Equivalent annual cost
From Wikipedia, the free encyclopedia
In finance the equivalent annual cost (EAC) is the cost per year of owning and operating an asset over its entire lifespan.
EAC is often used as a decision making tool in capital budgeting when comparing investment projects of unequal lifespans. For example if project A has an expected lifetime of 7 years, and project B has an expected lifetime of 11 years it would be improper to simply compare the net present values (NPVs) of the two projects, unless neither project could be repeated.
EAC is calculated by dividing the NPV of a project by the present value of an annuity factor. Equivalently, the NPV of the project may be multiplied by the loan repayment factor.
EAC=
The use of the EAC method implies that the project will be replaced by an identical project.
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A practical example
A manager must decide on which machine to purchase:
Machine A Investment cost $50,000 Expected lifetime 3 years Annual maintenance $13,000
Machine B Investment cost $150,000 Expected lifetime 8 years Annual maintenance $7,500
The cost of capital is 5%.
The EAC for machine A is: ($50,000/A3,5)+$13,000=$31,360 The EAC for machine B is: ($150,000/A8,5)+$7,500=$30,708 The conclusion is to invest in machine B since it has a lower EAC. Note: The loan repayment factors (A values) are for t years (3 or 8 years) and 5% cost of capital. A3,5 is given by = 2.723 and A8,5 is given by = 6.463. (See ordinary annuity formulae for a derivation.) The larger an A value is, the greater the present value is on a succession of future annuity payments, thus contributing to a smaller annual cost.
Alternative method:
The manager calculates the NPV of the machines:
Machine A EAC=$85,400/A3,5=$31,360 Machine B EAC=$198,474/A8,5=$30,708 Note: To get the numerators add the present value of the annual maintenance to the purchase price. For example, for Machine A: 50,000 + 13,000/1.05 +
From Wikipedia, the free encyclopedia
In finance the equivalent annual cost (EAC) is the cost per year of owning and operating an asset over its entire lifespan.
EAC is often used as a decision making tool in capital budgeting when comparing investment projects of unequal lifespans. For example if project A has an expected lifetime of 7 years, and project B has an expected lifetime of 11 years it would be improper to simply compare the net present values (NPVs) of the two projects, unless neither project could be repeated.
EAC is calculated by dividing the NPV of a project by the present value of an annuity factor. Equivalently, the NPV of the project may be multiplied by the loan repayment factor.
EAC=
The use of the EAC method implies that the project will be replaced by an identical project.
[edit]
A practical example
A manager must decide on which machine to purchase:
Machine A Investment cost $50,000 Expected lifetime 3 years Annual maintenance $13,000
Machine B Investment cost $150,000 Expected lifetime 8 years Annual maintenance $7,500
The cost of capital is 5%.
The EAC for machine A is: ($50,000/A3,5)+$13,000=$31,360 The EAC for machine B is: ($150,000/A8,5)+$7,500=$30,708 The conclusion is to invest in machine B since it has a lower EAC. Note: The loan repayment factors (A values) are for t years (3 or 8 years) and 5% cost of capital. A3,5 is given by = 2.723 and A8,5 is given by = 6.463. (See ordinary annuity formulae for a derivation.) The larger an A value is, the greater the present value is on a succession of future annuity payments, thus contributing to a smaller annual cost.
Alternative method:
The manager calculates the NPV of the machines:
Machine A EAC=$85,400/A3,5=$31,360 Machine B EAC=$198,474/A8,5=$30,708 Note: To get the numerators add the present value of the annual maintenance to the purchase price. For example, for Machine A: 50,000 + 13,000/1.05 +