The Equivalent Annual Cost (EAC) is a financial metric used to compare the annualized costs of different investment projects or assets with varying lifespans. EAC calculates the cost per year of owning, operating, and maintaining an asset over its lifespan, allowing businesses to make more informed decisions when comparing projects or equipment. By converting total costs into an annual figure, EAC enables a straightforward comparison, even when assets have different lifetimes or require different levels of investment. This method is widely used in capital budgeting to select the most cost-effective option that meets operational needs over time.
Key Components of EAC
- Initial Investment (in ₹): This includes the upfront purchase or installation cost of an asset or project, expressed in rupees.
- Operating and Maintenance Costs (in ₹): Ongoing costs associated with operating, servicing, or repairing the asset, also in rupees.
- Residual Value or Salvage Value (in ₹): The value of the asset at the end of its useful life, if any, subtracted from the total costs to represent net costs.
The EAC formula in rupees is given as:
EAC= NPV (Net Present Value of Costs)/Annuity Factor
Where:
- NPV represents the present value of all costs over the asset’s life, calculated in rupees.
- Annuity Factor is based on the discount rate (cost of capital in percentage) and the asset’s lifespan in years.
Alternatively, for cases where NPV isn’t calculated separately, EAC can be computed as:
EAC=Initial Cost×Discount Factor−Salvage Value×Discount Factor/Annuity Factor
This formula incorporates the time value of money, ensuring future cash flows are discounted correctly, a crucial aspect of capital budgeting.
Example of EAC Calculation
Suppose a company in India needs to decide between two machines, A and B, each priced and maintained in rupees:
- Machine A costs ₹500,000, with a lifespan of 5 years and annual maintenance of ₹80,000.
- Machine B costs ₹750,000, with a lifespan of 8 years and annual maintenance of ₹60,000.
- The company’s discount rate (cost of capital) is 10%.
Using the EAC formula, we calculate the EAC in rupees for each machine. The option with the lower EAC represents the most cost-effective choice on an annualized basis, accounting for the asset’s lifespan and maintenance needs in rupees.
Applications of EAC in India
- Capital Budgeting Decisions: In India, companies use EAC to make investment decisions, such as selecting between machinery, buildings, or technology infrastructure. By choosing the option with the lowest EAC in rupees, they minimize their annual operating costs.
- Replacement Planning: EAC can help companies decide when it’s financially sensible to replace older assets with newer models by comparing the EAC of new equipment against the ongoing costs of the old.
- Lease vs. Buy: When companies consider leasing versus buying assets, EAC helps calculate the annualized cost of each option, making it easier to decide which is more cost-effective in rupees.
Advantages and Limitations of EAC
- Advantages: EAC simplifies the comparison between projects with different costs and lifespans by translating them into a single rupee-based annual cost. It considers the time value of money, ensuring future costs are accurately discounted.
- Limitations: EAC assumes that cash flows remain stable over the asset’s life, which may not be accurate if maintenance costs rise over time or if inflation rates change. Additionally, EAC calculations rely on an accurate discount rate; an incorrect rate may lead to misleading conclusions.
Conclusion
The Equivalent Annual Cost metric is a powerful tool for businesses in India to make informed capital investment decisions. By calculating the annualized cost in rupees, EAC provides a clear picture of the most cost-effective option when comparing assets or projects with different lifespans. It allows firms to select investments that minimize costs and maximize returns over the long term, contributing to more efficient capital allocation. However, it is essential to account for assumptions like the discount rate and stable cash flows to ensure accurate, relevant results.
