Equivalent Annual Annuity Approach (EAA)
What Is the Equivalent Annual Annuity Approach?
The equivalent annual annuity approach is one of two methods utilized in capital budgeting to compare mutually exclusive projects with inconsistent lives. The EAA approach computes the steady annual cash flow generated by a project over its lifespan in the event that it was an annuity. At the point when used to compare projects with inconsistent lives, an investor ought to pick the one with the higher EAA.
Understanding the Equivalent Annual Annuity Approach (EAA)
The EAA approach utilizes a three-step cycle to compare projects. The current value of the steady annual cash flows is precisely equivalent to the project's net present value. The primary thing an analyst does is work out each project's NPV over its lifetime. From that point onward, they figure each project's EAA so the current value of the annuities is precisely equivalent to the project's NPV. Ultimately, the analyst compares each project's EAA and chooses the one with the highest EAA.
For instance, expect a company with a weighted average cost of capital of 10% is looking at two projects, An and B. Project A has a NPV of $3 million and an estimated life of five years, while Project B has a NPV of $2 million and an estimated life of three years. Utilizing a financial calculator, Project A has an EAA of $791,392.44, and Project B has an EAA of $804,229.61. Under the EAA approach, the company would pick Project B since it has the higher equivalent annual annuity value.
Special Considerations
Ascertaining the Equivalent Annual Annuity Approach
Frequently, an analyst will utilize a financial calculator, utilizing the ordinary present value and future value capabilities to track down the EAA. An analyst can involve the accompanying formula in a bookkeeping sheet or with a normal non-financial calculator with the very same outcomes.
- C = (r x NPV)/(1 - (1 + r)-n )
Where:
- C = equivalent annuity cash flow
- NPV = net present value
- r = interest rate per period
- n = number of periods
For instance, think about two projects. One has a seven-year term and a NPV of $100,000. Different has a nine-year term and a NPV of $120,000. The two projects are discounted at a 6 percent rate. The EAA of each project is:
- EAA Project one = (0.06 x $100,000)/(1 - (1 + 0.06)-7 ) = $17,914
- EAA Project two = (0.06 x $120,000)/(1 - (1 + 0.06)-9 ) = $17,643
Project one is the better option.
Features
- The equivalent annual annuity approach is one of two methods utilized in capital budgeting to compare mutually exclusive projects with inconsistent lives.
- Frequently, an analyst will utilize a financial calculator, utilizing the regular present value and future value capabilities to track down the EAA.
- At the point when used to compare projects with inconsistent lives, an investor ought to pick the one with the higher equivalent annual annuity.
