What Is the Equivalent Annual✱ Annuity (EAA) Approach?

The equivalent annual annuity (EAA) approach is one of two methods used in 澳洲幸运5官方开奖结果体彩网:capital budgeting to compare 澳洲幸运5官方开奖结果体彩网:mutually exclusive projects with unequal lives. The EAA approach calculates the constant annual cash flow generated by a project over its lifespan if it were an annuity. When used to compare projects with unequal lives, an investo🍒r should choose the one with theꦜ higher EAA.

Understand▨ing the Equivalent Annual Annuity (EAA) Approach

The EAA approach uses a three-step 澳洲幸运5官方开奖结果体彩网:process to compare projects. The present value of the constant annual cash flow is exactly equal to the project's 澳洲幸运5官方开奖结果体彩网:net present value (NPV). The first thing an analyst does is calculate each project's NPV over its lifetime. After that, they compute ♊each project's EAA so that the present value of the annuities is exactly equal to the project's NPV. Lastly, the analyst compares each project's EAA and selects the one with the highest EAA.

For example, let's say a company with a 澳洲幸运5官方开奖结果体彩网:weighted average cost of capital of 10% is comparing two projects, A and B. Project A has an NPV of $3 million and an estimated life of five years, while Project B has an NPV of $2 million and an estimated life of three years. Using a financial calculator, Project A has an EAA of $791,392.44, and Project B has an EAA of $804,229.61. Under the EAA approach, the company wou🌳ld choose Project B since it has the higher equivalent annual annuity value.

Calculating the Equivalent Annual Annuity (EAA)

Often, an analyst will use a financial calculator with the typical present value and 澳洲幸运5官方开奖结果体彩网:future value functions to find the EAA.

An analyst can use the following formula in a spreadsheet or with a non-financial calculator ꧅with exactly the same results.

• C = (r x NPV) / (1 - (1 + r)^-n )

Where:

• C = equivalent annuity cash flow
• NPV = net present value
• r = interest rate per period
• n = number of periods

For example, consider two projects. Project A has a seven-year term and an NPV of $100,000. Project B has a nine-year term and an NPV of $120,000. Both projects are discounted at a 6 perc🤡ent rate. The EAA of each project is:

• EAA Project A = (0.06 x $100,000) / (1 - (1 + 0.06)^-7 ) = $17,914
• EAA Project B = (0.06 x $120,000) / (1 - (1 + 0.06)^-9 ) = $17,643

Project A is the better option.

The Bottom Line

The equivalent annual annuity approach is a method used to compare projects that will each last a 💛specific amount of time. You can use a fi🦂nancial calculator to help you determine which project is best, or you can try your hand at these formulas.