Equivalent Annual Cost - EAC
What Is the Equivalent Annual Cost (EAC)?
Equivalent annual cost (EAC) is the annual cost of buying, operating, and keeping an asset over its whole life. Firms frequently use EAC for capital budgeting decisions, as it permits a company to compare the cost-viability of different assets with inconsistent lifespans.
Grasping the Equivalent Annual Cost (EAC)
Equivalent annual cost (EAC) is utilized for different purposes, including capital budgeting. Be that as it may, it is utilized generally normal to break down at least two potential projects with various lifespans, where costs are the most pertinent variable.
Different purposes of EAC incorporate computing the optimal life of an asset, deciding whether leasing or purchasing an asset is the better option, deciding the extent of which maintenance costs will impact an asset, deciding the essential cost savings to support purchasing another asset, and deciding the cost of keeping existing equipment.
The EAC calculation factors in a discount rate or the cost of capital. Cost of capital is the required return important to make a capital budgeting project — like building another factory — worthwhile. Cost of capital incorporates the cost of debt and the cost of equity and is utilized by companies inside to judge whether a capital project is worth the expenditure of resources.
The Formula for the Equivalent Annual Cost
Step by step instructions to Calculate the Equivalent Annual Cost
- Take the asset price or cost and duplicate it by the discount rate.
- The discount rate is likewise called the cost of capital, which is the required return important to make a capital budgeting project, like building another factory, worthwhile.
- In the denominator add 1 + the discount rate and raise the outcome as an example to the number of years for the project. Take away the outcome by 1 and gap the numerator figure by the denominator.
- Numerous financial online mini-computers are accessible to ascertain EAC.
Illustration of the Equivalent Annual Cost
As stated before, EAC permits managers to compare NPVs of various projects over various periods, to decide the best option accurately. Think about two alternative investments in machinery equipment:
- Machine A has the accompanying:
- An initial capital outlay of $105,000
- An expected lifespan of three years
- An annual maintenance expense of $11,000
- Machine B has the accompanying:
- An initial capital outlay of $175,000
- An expected lifespan of five years
- An annual maintenance expense of $8,500
The cost of capital for the company settling on the choice is in this way 5%.
Next, we ascertain the EAC, which is equivalent to the net present value (NPV) separated by the current value annuity factor or A(t,r), while considering the cost of capital or r, and the number of years being referred to or t.
The annuity factor is calculated as follows:
Utilizing the formula over, the annuity factor or A(t,r) of each project must be calculated. These calculations would be as per the following:
Next, the initial costs must be separated by the annuity factor or A(t,r) while adding in the annual maintenance cost. The calculation for EAC is:
By normalizing the annual cost, a manager in charge of a capital budgeting decision where cost is the main issue would choose Machine B since it has an EAC that is $636 lower than Machine A.
The Difference Between the Equivalent Annual Cost and the Whole-life Cost
Whole-life cost is the total expense of possessing an asset over its whole life, from purchase to, not entirely set in stone by financial analysis. It is otherwise called a "life-cycle" cost, which incorporates purchase and establishment, design and building costs, operating costs, maintenance, associated financing costs, depreciation, and disposal costs.
Whole-life cost likewise considers certain costs that are generally disregarded, for example, those connected with environmental and social impact factors.
The equivalent annual cost (EAC) is the annual cost of purchasing, operating, and keeping an asset over its whole life while the whole life cost is the total cost of the asset over its whole life.
Limitations of Using the Equivalent Annual Cost
A limitation with EAC, similarly as with numerous capital budgeting decisions, is that the discount rate or cost of capital must be estimated for each project. Tragically, the forecast can end up being inaccurate, or variables can change over the life of the project or life of the asset that is be thought of.
- EAC is frequently utilized by firms for capital budgeting decisions, as it permits a company to compare the cost-viability of different assets that have inconsistent lifespans.
- Equivalent annual cost (EAC) is the annual cost of purchasing, operating, and keeping an asset over its whole life.
- EAC permits managers to compare the net present values of various projects over various periods, to decide the best option accurately.