Equivalent Annual Cost

Updated on May 2, 2024
Article byKhalid Ahmed
Reviewed byDheeraj Vaidya, CFA, FRM

What Is Equivalent Annual Cost?

Equivalent Annual Cost (EAC) is a vital tool for businesses in determining the total cost incurred in owning, operating, and managing any asset annually throughout its useful lifetime. It mainly serves as a tool of capital budgeting to assess the capital cost efficiency for assets having unequal lifespans.

Equivalent Annual Cost

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For eg:
Source: Equivalent Annual Cost (wallstreetmojo.com)

Managers use this financial metric to make correct purchasing decisions for various assets with varying lifespans in a standardized manner. Therefore, it is the most helpful project management technique for comparing two projects with unequal but repeating lifecycles. In addition, it enables one to determine whether purchasing an asset is preferable to leasing it and vice versa.

Key Takeaways

  • Equivalent Annual Cost (EAC) is a valuable capital budgeting tool for companies to determine the total annual cost incurred in buying, running, and maintaining an asset during its useful lifespan.
  • In addition, equivalent annual cost analysis helps choose the best and most profitable projects and assets for investment by comparing the cost of buying, running, and handling assets with different lifespans.
  • This method has advantages and disadvantages, but cost-cutting through the best decision-making outweighs its disadvantages.
  • Moreover, this method does not consider Non –financial factors, inflation, and cash flow changes while ascertaining the asset’s value.

Equivalent Annual Cost Explained

Equivalent Annual Cost is defined as the net present value of any purchased asset plus maintenance and operations costs divided by the current value of the annuity factor. In other words, EAC aids budgetary decision-making by converting the cost of an asset into an equivalent yearly amount. This method easily compares the cost-effectiveness of two investments that have different lifespans. Furthermore, it is a must-have tool for determining the impact of maintenance costs on ownership.

Therefore, one can use the Equivalent annual cost method to determine whether keeping an existing piece of equipment will save money over purchasing new equipment. In addition, managers gain an essential decision-making tool in Equivalent annual cost analysis, which assists them in evaluating various options and selecting the best. As a result, this financial metric causes businesses to save revenue while increasing their profit margins. Nevertheless, to arrive at an accurate figure, all of the features of this tool rely on a firm’s correct cost of capital.

Every business faces the challenge of replacing or repairing equipment to keep operations running smoothly. Because the costs associated with such decisions are enormous, every company must make the best decision based on EAC. Thus, companies use the equivalent annual cost equation in the following steps to make the best decisions:

  • Firstly, calculating the net present value cost for each potential substitution cycle;
  • Secondly, determining the equivalent annual cost for each potential substitution cycle; and 
  • The last step is to select the best option with the lowest EAC.

Hence, the Equivalent annual cost analysis assists businesses in making informed investment decisions by comparing the annualized cost of each asset option with its lowest EAC as the most cost-effective investment option.

Formula

EAC has a formula utilizing asset price, discount rate, and the number of cycles for which the asset will be used. Therefore,

Equivalent Annual Cost, EAC = Asset Price x Discount Rate / 1 – (1 + Discount Rate) – n + annual maintenance costs

Where n = periods

Other than the above formula, EAC can also get calculated using NPV, the number of periods, and interest rate, as shown below:

  • EAC= net present value/annuity factor of NPV with a certain number of periods and interest rate. Or,
  • EAC = NPV/A t, r where A= annuity factor of NPV
  • t = number of periods
  • r = interest rate

Calculation Example

Let us look at a calculation example to observe the importance and usefulness of the Equivalent annual cost equation in making correct decisions by the companies. Suppose Oak Network Co. has decided to buy motherboard-making equipment for its plant in Nevada. It has two companies to buy the motherboard-making equipment, namely Company A & B.

Company ACompany B
Asset price = $130000Expected lifespan = 5 yrs. Discount rate = 10 %annual maintenance cost = $5000using the data in the formula of  
Equivalent Annual Cost (EAC) = (Asset Price x Discount Rate) / 1 – (1 + Discount Rate)-n + annual maintenance costs  
EAC = [($130000 *10 %)/ 1- (1+10%) ^-5] + $5000EAC
= [130000*0.10/ 1- 0.620] + $5000        
=(13000/0.38 )+5000         
=34210.52 + 5000
EAC = $39210.52
Asset price = $150000Expected lifespan = 4 yrs. Discount rate = 10%annual maintenance cost = $7000using the data in the formula
Equivalent Annual Cost (EAC) = (Asset Price x Discount Rate) / 1 – (1 + Discount Rate)-n + annual maintenance costs  
EAC = [($150000 * 10%)/1- (1+10%) ^-7] + $7000          
= [150000*0.10/ 1-0.513] + 7000         
= 15000/ 0.487 +7000         
= 30800.82+ 7000
EAC = $37800.82

From the above table, one finds that:

  • Company A is affordable and worthy of buying motherboard-making equipment on preliminary observation.
  • Company B appears costly and not worth buying motherboard-making equipment on preliminary observation.
  • After EAC calculation, company A’s motherboard-making equipment becomes costlier than company B’s (from the table above).
  • Subsequently, after EAC calculation, company B’s motherboard-making equipment becomes affordable and best buy than company A’s (from the table above).

Thus, by comparing the investment options, Oak network Co .can make the best decision to buy company B’s motherboard-making equipment because it is the most cost-effective.

Advantages And Disadvantages

This financial metric has pros and cons as a tool in capital budgeting, as depicted in the table below.

AdvantagesDisadvantages
Managers utilize it to choose the best cost-effective option to invest in.Equivalent annual cost analysis assumes that costs and cash flows are constant over the asset’s lifetime.
Companies cut costs, save money, and increase their profit margin. This tool excludes the impact of taxation.
It helps firms to avoid cheaper and non-durable equipment from buying.The assumption of replacing one asset with another similar investment needs to be fixed.
More importantly, the tool enables companies to bypass the wrong asset for purchasing or leasing, which may hamper their business adversely.Therefore, this analysis is only as accurate as the cost estimates used to calculate it. Thus, if the cost estimates are accurate, the method may lead to correct investment decisions.
This method becomes an effective personal tool for deciding on big purchases like a car. They do not consider the effect of inflation on cash flow and capital cost.

Frequently Asked Questions (FAQs)  

How to calculate equivalent annual costs in excel?

· Open a new excel spreadsheet and enter the relevant data of the asset, including initial cost, useful lifeline, and discount rate.
In cell D6, Calculate the EAC using the formula.
= (G4*H4/1) – (1+H4) –n + K
 
Format the EAC value as a dollar or number with two decimal places.
Therefore, by following these steps, you can use Excel to calculate the Equivalent annual cost for any asset.
calculate the Equivalent annual cost

The equivalent annual cost method is useful in determining?

This method is quite helpful in determining the best project or asset option for investment purposes and avoiding losses by installing cheap and weak pieces of equipment for production in companies.

When to use Equivalent annual cost?

This analysis can be used in various situations, including:
· Comparing asset options
· Long-term planning
· Lease vs Buy analysis
· Replacement analysis

This has been a guide to what is Equivalent Annual Cost. Here, we explain it with its formula, calculation, examples, advantages, and disadvantages. You can learn more about from the following articles –

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