A Practical Example
A manager must decide on which machine to purchase:
Machine A
Investment cost $50,000
Expected lifetime 3 years
Annual maintenance $13,000
Machine B
Investment cost $150,000
Expected lifetime 8 years
Annual maintenance $7,500
The cost of capital is 5%.
The EAC for machine A is: ($50,000/)+$13,000=$31,360
The EAC for machine B is: ($150,000/)+$7,500=$30,708
The conclusion is to invest in machine B since it has a lower EAC.
Note: The loan repayment factors (A values) are for t years (3 or 8 years) and 5% cost of capital. is given by = 2.723 and is given by = 6.463. (See ordinary annuity formulae for a derivation.) The larger an A value is, the greater the present value is on a succession of future annuity payments, thus contributing to a smaller annual cost.
Alternative method:1
The manager calculates the NPV of the machines:
Machine A EAC=$85,400/=$31,360
Machine B EAC=$198,474/=$30,708
Note: To get the numerators add the present value of the annual maintenance to the purchase price. For example, for Machine A: 50,000 + 13,000/1.05 + 13,000/(1.05)^2 + 13,000/(1.05)^3 = 85,402.
The result is the same, although the first method is easier it is essential that the annual maintenance cost is the same each year.
Alternatively the manager can use the NPV method under the assumption that the machines will be replaced with the same cost of investment each time. This is known as the chain method since 8 repetitions of machine A are chained together and 3 repetitions of machine B are chained together. Since the time horizon used in the NPV comparison must be set to 24 years (3*8=24) in order to compare projects of equal length, this method can be slightly more complicated than calculating the EAC. In addition, the assumption of the same cost of investment for each link in the chain is essentially an assumption of zero inflation, so a real interest rate rather than a nominal interest rate is commonly used in the calculations.
Read more about this topic: Equivalent Annual Cost
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—Henry David Thoreau (1817–1862)