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Equivalent annual cost (EAC) is a financial metric used to compare the costs of different investment projects or assets over a specified period, typically on an annual basis.
What is equivalent annual cost?
Equivalent annual cost helps in evaluating the total cost of ownership or investment allowing for easier comparison of projects with different lifespans, cash flow patterns, or initial costs.
EAC allows for a direct comparison between projects or investments that have different time horisons, cash flow patterns, or initial costs. Furthermore, EAC is a valuable tool in capital budgeting, helping decision-makers evaluate which investment option provides the most cost-effective solution
EAC assumes a constant annual cost, which may not always reflect the actual cash flows in real-world situations. It also assumes a constant discount rate, which may not hold in dynamic economic environments.
How to calculate the equivalent annual cost
- Take the asset price or cost and multiply it by the discount rate.
- The discount rate, also known as the cost of capital, is the required return to make a capital budgeting project, like building a new factory, worthwhile.
- In the denominator, add 1 to the discount rate and raise the result to the power of the number of years for the project. Subtract 1 from this result and divide the numerator by the denominator.
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