What Is the An identical Annual Annuity Approach?
The equivalent annual annuity approach is one in all two methods used in capital budgeting to test mutually distinctive projects with unequal lives. The EAA approach calculates the constant annual cash go with the flow generated via a problem over its lifespan if it was once as soon as an annuity. When used to test projects with unequal lives, an investor should choose the one with the higher EAA.
Key Takeaways
- The equivalent annual annuity approach is one in all two methods used in capital budgeting to test mutually distinctive projects with unequal lives.
- When used to test projects with unequal lives, an investor should choose the one with the higher equivalent annual annuity.
- Ceaselessly, an analyst will use a financial calculator, the usage of the on a regular basis supply worth and long run worth functions to hunt out the EAA.
An identical Annual Annuity Approach (EAA)
Understanding the An identical Annual Annuity Approach (EAA)
The EAA approach uses a three-step process to test projects. The prevailing worth of the constant annual cash flows is exactly an identical to the problem’s internet supply worth. The first thing an analyst does is calculate each and every problem’s NPV over its lifetime. After that, they compute each and every problem’s EAA so that the existing worth of the annuities is exactly an identical to the problem’s NPV. After all, the analyst compares each and every problem’s EAA and selects the one with the best possible EAA.
For instance, assume a company with a weighted cheap price of capital of 10% is comparing two projects, A and B. Mission A has an NPV of $3 million and an estimated existence of five years, while Mission B has an NPV of $2 million and an estimated existence of three years. The usage of a financial calculator, Mission A has an EAA of $791,392.44, and Mission B has an EAA of $804,229.61. Under the EAA approach, the company would choose Mission B as it has the higher equivalent annual annuity worth.
Specific Problems
Calculating the An identical Annual Annuity Approach
Ceaselessly, an analyst will use a financial calculator, the usage of the on a regular basis supply worth and long run worth functions to hunt out the EAA. An analyst can use the following method in a spreadsheet or with a regular non-financial calculator with exactly the an identical results.
- C = (r x NPV) / (1 – (1 + r)-n )
Where:
- C = equivalent annuity cash go with the flow
- NPV = internet supply worth
- r = interest rate in line with length
- n = number of categories
For instance, imagine two projects. One has a seven-year period of time and an NPV of $100,000. The other has a nine-year period of time and an NPV of $120,000. Every projects are discounted at a 6 % worth. The EAA of each and every problem is:
- EAA Mission one = (0.06 x $100,000) / (1 – (1 + 0.06)-7 ) = $17,914
- EAA Mission two = (0.06 x $120,000) / (1 – (1 + 0.06)-9 ) = $17,643
Mission one is the better chance.
