Economics Capital Budgeting Questions Medium
The equivalent annual cost (EAC) is a financial metric used in capital budgeting to determine the annual cost of an investment over its useful life. It represents the annualized cost of owning and operating an asset, taking into account factors such as initial investment, maintenance costs, salvage value, and the time value of money.
To calculate the EAC, the following steps are typically followed:
1. Determine the initial investment cost: This includes the upfront cost of acquiring the asset, such as purchase price, installation costs, and any other associated expenses.
2. Estimate the annual operating and maintenance costs: These costs include expenses related to the regular operation, maintenance, and repair of the asset. It may also include costs for insurance, taxes, and other ongoing expenses.
3. Determine the expected salvage value: This is the estimated value of the asset at the end of its useful life. It represents the amount that can be recovered from selling or disposing of the asset.
4. Determine the useful life of the asset: This is the expected duration for which the asset will be used and generate benefits.
5. Calculate the present value of cash flows: Using a discount rate, typically the cost of capital or the required rate of return, the future cash flows (including the salvage value) are discounted to their present value.
6. Calculate the equivalent annual cost: The present value of cash flows is divided by the present value annuity factor, which is calculated using the discount rate and the useful life of the asset. This provides the annualized cost of owning and operating the asset over its useful life.
The formula for calculating the EAC is as follows:
EAC = (Initial Investment + Annual Operating and Maintenance Costs - Salvage Value) / Present Value Annuity Factor
By calculating the EAC, decision-makers can compare the costs of different investment options on an annual basis, facilitating better decision-making in capital budgeting.