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EAC is often used as a decision making tool in Capital Budgeting when comparing investment projects of unequal lifespans. For example if project A has an expected lifetime of 7 years, and project B has an expected lifetime of 11 years it would be improper to simply compare the net present values (NPVs) of the two projects, unless neither project could be repeated. EAC is calculated by dividing the NPV of a project by the ''present value of an Annuity '' factor. Equivalently, the NPV of the project may be multiplied by the ''loan repayment factor''. The use of the EAC method implies that the project will be replaced by an identical project. 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%.
Where A is the loan repayment factor for t years and 5% cost of capital. The conclusion is to invest in machine B since it has a lower EAC. Alternative method: The manager calculates the NPV of the machines:
The result is the same, although the first method is easier it is essential that the annual maintenance cost is the same each year.
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. SEE ALSO
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