In finance, the equivalent annual cost (EAC) is the cost per year of owning and operating an asset over its entire lifespan. It is calculated by dividing the negative NPV of a project by the "present value of

annuity In investment, an annuity is a series of payments made at equal intervals based on a contract with a lump sum of money. Insurance companies are common annuity providers and are used by clients for things like retirement or death benefits. Examples ...

factor": :

\mathrm = -\frac

, where

= \frac

where r is the annual interest rate and t is the number of years. Alternatively, EAC can be obtained by multiplying the NPV of the project by the "loan repayment factor". EAC is often used as a decision-making tool in

capital budgeting Capital budgeting in corporate finance, corporate planning and accounting is an area of capital management that concerns the planning process used to determine whether an organization's long term capital investments such as new machinery, repla ...

when comparing investment projects of unequal lifespans. However, the projects being compared must have equal risk: otherwise, EAC must not be used. The technique was first discussed in 1923 in engineering literature, and, as a consequence, EAC appears to be a favoured technique employed by

engineer Engineers, as practitioners of engineering, are professionals who Invention, invent, design, build, maintain and test machines, complex systems, structures, gadgets and materials. They aim to fulfill functional objectives and requirements while ...

s, while

accountant An accountant is a practitioner of accounting or accountancy. Accountants who have demonstrated competency through their professional associations' certification exams are certified to use titles such as Chartered Accountant, Chartered Certif ...

s tend to prefer

net present value The net present value (NPV) or net present worth (NPW) is a way of measuring the value of an asset that has cashflow by adding up the present value of all the future cash flows that asset will generate. The present value of a cash flow depends on ...

(NPV) analysis. Such preference has been described as being a matter of professional education, as opposed to an assessment of the actual merits of either method. In the latter group, however, the Society of Management Accountants of Canada endorses EAC, having discussed it as early as 1959 in a published

monograph A monograph is generally a long-form work on one (usually scholarly) subject, or one aspect of a subject, typically created by a single author or artist (or, sometimes, by two or more authors). Traditionally it is in written form and published a ...

(which was a year before the first mention of NPV in accounting textbooks).

Application

EAC can be used in the following scenarios: #Assessing alternative projects of unequal lives (where only the costs are relevant) in order to address any built-in bias favouring the longer-term investment. #Determining the optimum economic life of an asset, through charting the change in EAC that may occur due to the fluctuation of operating costs and salvage values over time. #Assessing whether leasing an asset would be more economical than purchasing it. #Assessing whether increased maintenance costs will economically change the useful life of an asset. #Calculating how much should be invested in an asset in order to achieve a desired result (i.e., purchasing a storage tank with a 20-year life, as opposed to one with a 5-year life, in order to achieve a similar EAC). #Comparing to estimated annual cost savings, in order to determine whether it makes economic sense to invest. #Estimating the cost savings required to justify the purchase of new equipment. #Determining the cost of continuing with existing equipment. #Where an asset undergoes a major overhaul, and the cost is not fully reflected in salvage values, to calculate the optimum life (i.e., lowest EAC) of holding on to the asset.

A practical example

A manager must decide on which machine to purchase, assuming an annual interest rate of 5%:demonstrated at The conclusion is to invest in machine B since it has a lower EAC.

Canadian context with capital cost allowance

Such analysis can also be carried out on an after-tax basis, and extensive work has been undertaken in Canada for investment appraisal of assets subject to its

capital cost allowance Capital Cost Allowance (CCA) is the means by which Canadian businesses may claim depreciation expense for calculating taxable income under the '' Income Tax Act''. Similar allowances are in effect for calculating taxable income for provincial purpo ...

regime for computing depreciation for income tax purposes. It is subject to a three-part calculation: #Determination of the after-tax NPV of the investment #Calculation of the after-tax NPV of the operating cost stream #Applying a sinking fund amortization factor to the after-tax amount of any salvage value. In mathematical notation, for assets subject to the general half-year rule of CCA calculation, this is expressed as:

\mathrm = \frac + \frac - \frac

where: : = Capital recovery (amortization) factor : = Sinking fund amortization factor : = Investment : = Estimated salvage value :

= Operating expense stream : = CCA rate per year for tax purposes : = rate of taxation : = number of years : =

cost of capital In economics and accounting, the cost of capital is the cost of a company's funds (both debt and equity), or from an investor's point of view is "the required rate of return on a portfolio company's existing securities". It is used to evaluate ne ...

, rate of interest, or minimum rate of return (whichever is most relevant) and where

A_ = \frac

F_ = \frac.

References

External links

Equivalent Annual Cost - EAC – Calculator
Management accounting Corporate finance Capital budgeting Engineering economics

Application

A practical example

Canadian context with capital cost allowance

See also

References

Further reading

External links