One of the key metrics used in finance and capital budgeting to determine which investment options are the most cost-effective is Equivalent Annual Cost, or EAC. The concept of EAC provides a way of comparing projects, assets, or investment alternatives that cover different time periods by converting their costs into a consistent, annualized figure. This allows the decision-makers to make the right decision based on a more explicit understanding of the annual cost impact of an investment throughout its life cycle.
This article will discuss the EAC formula, why it is important in the decision-making process, an example to make things clearer, and how it compares with the WLC approach. It will further discuss situations where one might be better than the other.
Equivalent Annual Cost is what?
The Equivalent Annual Cost is the measure that gives an estimation of constant annual costs over the asset's lifetime through ownership, operation, and maintenance. Calculating EAC enables comparison among investments or projects that may differ in lifespan, inasmuch as the whole costs for those projects would be expressed as equivalent amounts of an annual amount, so a more uniform approach may be seen for better comparison and judgment in determining decisions by their long-run cost implications of the options presented.
The EAC approach is very useful while making a project, assets, or investment evaluation if they have recurring costs of maintenance, operating expenses, or replacement costs. It reflects the initial investment and operation over the life of an asset or project.
Formula for Equivalent Annual Cost (EAC)
The formula for calculating EAC is derived from the Net Present Value (NPV) of all costs associated with the asset or project over its expected life. Once the NPV of all costs is calculated, the EAC converts that into an annual cost figure. The formula for EAC is as follows:
EAC= (NVP of Costs)/(∑▒〖Discount Factor〗)
Where:
NPV of Costs is the sum of all costs t