Equivalent Annual Cost (EAC)

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  • Post last modified:December 15, 2023
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Equivalent Annual Cost (EAC) is a financial metric used to compare the costs of different projects or investment opportunities on an annual basis. It represents the annual cost of an investment over its entire life, converted into an equivalent annual amount. EAC is particularly useful for comparing projects with different lifespans or cash flow patterns.

The formula for calculating Equivalent Annual Cost (EAC) is as follows:

\[ EAC = \frac{NPV \times (1 + r)}{\left(\frac{(1 + r)^n – 1}{r}\right)} \]

– \( NPV \) is the Net Present Value of the project or investment.
– \( r \) is the discount rate (the rate used to discount future cash flows to their present value).
– \( n \) is the number of years or periods over which the costs are spread.

Alternatively, EAC can also be calculated using the following formula, which is more straightforward when comparing projects with the same lifespan:

\[ EAC = \frac{A}{(1 – (1 + r)^{-n})} \]

– \( A \) is the annual cash flow (positive or negative) associated with the investment.

In both formulas, the EAC represents the annual cost that, when discounted at the given rate, is equivalent to the present value of the costs associated with the investment.

Key points to consider when using EAC:

1. **Comparative Analysis:** EAC is particularly useful when comparing projects with different lifespans or cash flow patterns. It provides a way to standardize costs on an annual basis for easier comparison.

2. **Discount Rate:** The choice of discount rate is crucial in calculating EAC. The discount rate reflects the opportunity cost of capital and is used to bring future cash flows to their present value.

3. **Sensitivity Analysis:** Sensitivity analysis can be performed by calculating EAC under different discount rates to assess how changes in the discount rate impact the equivalent annual cost.

4. **Cash Flows:** Accurate estimation of cash flows is essential for EAC calculations. This includes both initial investment costs and expected future cash inflows or outflows.

Equivalent Annual Cost is a valuable tool for decision-makers when evaluating and comparing investment opportunities, especially when the projects have different time horizons or cash flow patterns. It allows for a more meaningful comparison by expressing costs on a standardized annual basis.