What Is the Equivalent Annual Cost (EAC)?

Summary

This video explains the concept of Equivalent Annual Cost (EAC), which represents the annual cost of owning, operating, and maintaining an asset over its entire life. EAC is a key tool for companies in capital budgeting, particularly when comparing projects or assets with different lifespans. The video covers its calculation using the discount rate or cost of capital, and contrasts EAC with whole life cost, which includes all expenses from purchase to disposal. Viewers will learn how EAC helps managers make cost-effective decisions, evaluate asset options, and compare net present values across projects to determine the most efficient choice.

Takeaways

• 😀 Equivalent Annual Cost (EAC) is the annual cost of owning, operating, and maintaining an asset over its entire life.
• 😀 Companies use EAC for capital budgeting decisions, especially when comparing assets with different lifespans.
• 😀 EAC helps determine the most cost-effective option between multiple projects or assets.
• 😀 The calculation of EAC requires a discount rate, also known as the cost of capital.
• 😀 The cost of capital includes both the cost of debt and the cost of equity.
• 😀 EAC converts the total cost of an asset over its life into an annualized figure for easier comparison.
• 😀 Whole life cost refers to the total expense of owning an asset from purchase to disposal, including installation, maintenance, financing, and disposal costs.
• 😀 EAC is useful for evaluating optimal asset life, comparing leasing versus purchasing, and assessing maintenance costs.
• 😀 Using EAC allows managers to compare the net present values of projects over different periods.
• 😀 Key factors in EAC calculations include asset cost, operational costs, maintenance, discount rate, and lifespan.
• 😀 By considering EAC, companies can make informed decisions about acquiring, maintaining, or replacing assets.

Q & A

What is Equivalent Annual Cost (EAC)?

Equivalent Annual Cost (EAC) is the annual cost of owning, operating, and maintaining an asset over its entire life. It helps companies compare the cost-effectiveness of different assets.

Why is EAC important for capital budgeting decisions?

EAC is important for capital budgeting because it allows companies to compare assets or projects with different lifespans on a consistent annual cost basis, aiding in selecting the most cost-effective option.

What types of projects or decisions commonly use EAC analysis?

EAC is commonly used for evaluating alternative investments, determining optimal asset life, comparing leasing versus purchasing, assessing maintenance costs, and planning necessary cost savings for new assets.

What is the formula for calculating EAC?

The formula for EAC is EAC = SL / (1 + r)^n, where SL is the total cost of the asset, r is the discount rate or cost of capital, and n is the number of periods (years).

What does the discount rate in the EAC formula represent?

The discount rate represents the cost of capital, which includes the cost of debt and equity. It reflects the required return to make a capital budgeting project worthwhile.

How does EAC help compare projects with unequal lifespans?

EAC converts the total cost of each asset into an equivalent annual cost, allowing managers to directly compare the net present value of projects over different time periods and make an informed decision.

What is the difference between Whole Life Cost and EAC?

Whole Life Cost is the total expense of owning an asset from purchase to disposal, including all operational, maintenance, financing, and disposal costs. EAC converts this total cost into an annualized figure for easier comparison.

Can EAC be used to decide between leasing and purchasing an asset?

Yes, EAC can be used to evaluate the annual cost of owning versus leasing an asset, helping managers determine the most cost-effective approach.

How can managers use EAC to assess maintenance costs?

By calculating the EAC, managers can estimate the annual cost of maintaining an asset over its life, helping to plan budgets and evaluate whether maintenance expenses are justified.

What are the three key takeaways about EAC mentioned in the script?

1. EAC is the annual cost of owning, operating, and maintaining an asset over its life. 2. It is widely used in capital budgeting to compare assets with unequal lifespans. 3. EAC allows managers to compare net present values over different periods to choose the most cost-effective option.

How does calculating EAC help in making cost-effective machinery investment decisions?

By calculating the EAC of each machine, a manager can determine which machine has the lower annual cost, taking into account the cost of capital and annuity factor, leading to a more cost-effective investment decision.