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The equivalent annual annuity formula is used in capital budgeting to show the net present
value of an investment as a series of equal cash flows for the length of the investment. The
net present value(NPV) formula shows the present value of an investment that has uneven
cash flows. When comparing two different investments using the net present value method,
the length of the investment (n) is not taken into consideration. An investment with a 15
year term may show a higher NPV than an investment with a 4 year term. By showing the
NPV as a series of cash flows, the equivalent annual annuity formula provides a way to
factor in the length of an investment.
An example of how the equivalent annual annuity formula may be useful is comparing two
new projects where one project has a 15 year term and the other has a 4 year term.
Assume that both projects have the same NPV. The 4 year project will receive the return
sooner so it will show a higher cash flow when using the equivalent annual annuity formula.
In real life, comparing two investments will not always be so obvious and the formula
should be applied.
Another way of explaining the usefulness of the equivalent annual annuity formula is that an
investment with a shorter life span can be reinvested and the earnings on the reinvestment
is not taken into consideration when using the NPV formula. The equivalent annual annuity
formula provides a comparison relative to time which eliminates the need for considering
reinvestment with the same earnings as the current investment.
In finance the equivalent annual cost (EAC) is the cost per year of owning and operating an asset over its
entire lifespan.
EAC is often used as a decision making tool in capital budgeting when comparing investment projects of
unequal lifespans. For example if project A has an expected lifetime of 7 years, and project B has an expected
lifetime of 11 years it would be improper to simply compare the net present values (NPVs) of the two projects,
unless neither project could be repeated.
EAC is calculated by dividing the NPV of a project by the present value of an annuity factor. Equivalently, the
NPV of the project may be multiplied by the loan repayment factor.
EAC=
The use of the EAC method implies that the project will be replaced by an identical project.
A practical example
Machine A
Investment cost $50,000
Expected lifetime 3 years
Annual maintenance $13,000
Machine B
Investment cost $150,000
Expected lifetime 8 years
Annual maintenance $7,500
Alternative method:
Machine A EAC=$85,400/A3,5=$31,360
Machine B EAC=$198,474/A8,5=$30,708
Note: To get the numerators add the present value of the annual maintenance to the purchase price. For
example, for Machine A: 50,000 + 13,000/1.05 + 13,000/(1.05)^2 + 13,000/(1.05)^3 = 85,402.
The result is the same, although the first method is easier it is essential that the annual maintenance cost is the
same each year.
Alternatively the manager can use the NPV method under the assumption that the machines will be replaced
with the same cost of investment each time. This is known as the chain method since 8 repetitions of machine
A are chained together and 3 repetitions of machine B are chained together. Since the time horizon used in the
NPV comparison must be set to 24 years (3*8=24) in order to compare projects of equal length, this method
can be slightly more complicated than calculating the EAC. In addition, the assumption of the same cost of
investment for each link in the chain is essentially an assumption of zero inflation, so a real interest rate rather
than a nominal interest rate is commonly used in the calculations.
11.16 - Comparing Projects With Unequal Lives
As mentioned previously, NPV and IRR can sometimes lead to conflicting results in the analysis of
mutually exclusive projects. One reason for this potential problem is the timing of the cash flows of the
mutually exclusive projects. As a result, we need to adjust for the timing issue in order to correct this
problem.
There are two methods used to make the adjustments:
1.Replacement-chain method
2.Equivalent annual annuity
Once again, assume Newco is planning to add new machinery to its current plant. There are two
machines Newco is considering, with cash flows as follows:
Compare the two projects with unequal lives using both the replacement-chain method and the equivalent
annual annuity (EAA) approach.
1. Replacement-Chain Method
In this example, Machine A has an operating lifespan of six years. Machine B has an operating lifespan of
three years. The cash flows for each project are discounted by Newco's calculated WACC of 8.4%.
• NPV of Machine A is equal to $2,926.
• NPV of Machine B is equal to $1,735.
The initial analysis indicates that Machine A, with the greater NPV, should be the project chosen.
• The IRR of Machine A is equal to 8.3%.
• The IRR of Machine B is equal to 15.5%.
This analysis indicates that Machine B, with the greater IRR, should be the project chosen.
The NPV analysis and the IRR analysis have given us differing results. This is most likely due to the
unequal lives of the two projects. As such, we need to analyze the two projects over a common life.
For Machine A (project 1), the lifespan is six years. For Machine B (project 2), the lifespan is three years.
Given that the lifespan of the longest project is six years, in order to measure both over a common life, we
must adjust the lifespan of Machine B to six years.
Because the lifespan of Machine B is three years, the lifespan of this project needs to be doubled to equal
the six-year lifespan of Machine A. This indicates that another Machine B would have to be purchased (to
get two machines with a lifespan of three years each) to get to the six-year lifespan of Machine A - hence,
the replacement-chain method.
The initial analysis indicates that Machine B, with the greater NPV, should be the project chosen. Recall,
this is different from our first analysis where Machine A was chosen given its greater NPV.
• The IRR of Machine A remains 8.3%.
• The IRR of Machine B remains 15.5%.
Look Out!
Note, while the NPV has changed given the additional cash flows, the IRR for the projects remain
the same.
This analysis indicates that Machine B, with the greater IRR, should be the project chosen. Recall, this is
the same as our first analysis, where Machine B was chosen given its greater IRR.
With the cash flows adjusted with the replacement-chain method, both the NPV and the IRR arrive at the
same conclusion. With this adjusted analysis, Machine B (project 2), should be the project accepted.
2. Equivalent-Annual-Annuity Approach
While easy to understand, the replacement-chain method can be time consuming. A simpler approach is
the equivalent-annual-annuity approach.
Answer
Machine B should be the project chosen as it has the highest EAA, which is $678.10, relative to Machine
A whose EAA is $640.64.
As an example, suppose Newco unintentionally leaves out its inflation expectations when determining the
plant addition. Since inflation expectations are included in the WACC, and PV of each cash flow is
discounted by the WACC, the NPV will be incorrect and have a downward bias.
Equivalent Annual Annuity Approach (EAA)
Equivalent Annual Annuity approach (EAA) is another sophisticated technique used in capital
budgeting decisions. EAA determines the annual cost of the project over its economic life. It
is determined by dividing net present value (NPV) of the project by the present value
interest factor for annuity (PVIFAr,n) for a specific period and at a specific discount rate.
PVIFAr,n can be found in financial tables.
EAA is helpful when a project has to be selected from mutually exclusive projects with
unequal lives. The project with the highest Equivalent Annual Annuity (EAA) is more
attractive. If two mutually exclusive projects have equal EAA than the project with the
shorter economic life is more acceptable.
XEROX Photocopier
-4000 $1,000 $1,000 $1,000 $1,000 $1,000 $1,000 $1,000 $1,000 $1,000
NPV $986
NPV $1,758
Conclusion
Thus with Replacement chain analyis we find that the Chinese Photocopier project with 3 year life span has a higher NPV
than the 9 years XEROX project. Thus the financial analyst is likely to accept the machine with lower quality yet higher NPV.
This just illustrates what went wrong with letting China do business as it does. When the Chinese with command economy
are able to produce giffen products that leads to loss of market share of the American manufactured products simply
because the end consumers sees benefits in saving money with a cheap product that makes him the most money. Now you
replicate the behavior of the financial analyst, that had to choose from XEROX and the Chinese made photocopier, with that
of million other business managers across America and you get the picture as to why we the United States have lost its
domination in manufacturing sector. The bottom line seems to be the crucial decision making factor to businesses that rather
save money than to keep America on top as the World's leading manufacturer.