What is the Equivalent Annual Cost (EAC)?
How the EAC Works
EAC is often used as a tool in capital budget decision making for evaluating investments of unequal lifespans. The usage of EAC implies the continuation of the investments or project beyond its initial lifetime. If the project or projects are not to be repeated, then the NPV (net present value) method might be more appropriate for capital budgeting decisions.
The EAC formula is calculated as follows:
EAC = NPV/A t, r where A= the present value of an annuity factor
t = number of periods
r = interest rate
In other words, EAC is calculated by dividing the NPV of a project by the present value of an annuity factor.
Why the EAC Matters
Capital budgeting decisions require distinct methods for determining the costs and potential profitability of new projects. EAC is a method which is most useful for evaluating projects which are assumed to have unequal but repeating life spans. By contrast, when comparing two projects that have equal life spans, or that have unequal life spans but are assumed not to repeat, the best method may be to simply compare the NPVs.
Due to its applicability for projects with life spans that repeat indefinitely, the EAC method is often seen as an indication that the firm itself has a long operating horizon as a going concern, and therefore, is a financially healthy company.
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