Explain the concept of equivalent annual cost (EAC) and how it is used in capital budgeting decision making.

The concept of equivalent annual cost (EAC) is a financial metric used in capital budgeting to evaluate and compare different investment projects or alternatives. It represents the annual cost of an investment over its entire life, taking into account factors such as initial investment, operating costs, salvage value, and the time value of money.

In capital budgeting decision making, the EAC is used to determine the most cost-effective investment option among various alternatives. By converting all costs and benefits into equivalent annual amounts, it allows for a fair comparison of projects with different lifespans, cash flows, and initial investments.

To calculate the EAC, the following steps are typically followed:

1. Determine the cash flows: Identify all relevant cash inflows and outflows associated with the investment project. These may include initial investment, operating costs, maintenance expenses, salvage value, and any additional revenues or savings generated by the project.

2. Calculate the present value: Apply the concept of the time value of money by discounting all cash flows to their present value using an appropriate discount rate. This rate is usually the project's cost of capital or the required rate of return.

3. Determine the equivalent annual cost: Sum up the present values of all cash outflows (negative cash flows) and divide it by the present value of an annuity factor. The annuity factor is calculated using the discount rate and the project's lifespan.

4. Interpret the results: The resulting EAC represents the annual cost that would be equivalent to the investment project's cash flows over its entire life. A lower EAC indicates a more cost-effective investment option.

By using the EAC, decision-makers can compare investment projects with different cash flow patterns and durations on an equal basis. It helps in identifying the project that provides the best value for money and maximizes the return on investment. Additionally, the EAC considers the time value of money, ensuring that future cash flows are appropriately discounted to reflect their present value.

However, it is important to note that the EAC is just one of the many factors considered in capital budgeting decision making. Other factors such as risk, strategic fit, and qualitative aspects should also be taken into account to make a well-informed investment decision.