Equivalent Annual Annuity Approach - EAA


DEFINITION of 'Equivalent Annual Annuity Approach - EAA'

One of two methods used in capital budgeting to compare mutually exclusive projects with unequal lives. The equivalent annual annuity (EAA) approach calculates the constant annual cash flow generated by a project over its lifespan if it was an annuity. The present value of the constant annual cash flows is exactly equal to the project's net present value (NPV). When used to compare projects with unequal lives, the one with the higher EAA should be selected.

BREAKING DOWN 'Equivalent Annual Annuity Approach - EAA'

The EAA approach uses a three-step process to compare projects:

  1. Calculate each project's NPV over its lifetime.
  2. Compute each project's EAA, such that the present value of the annuities is exactly equal to the project NPV.
  3. Compare each project's EAA and select the one with the highest EAA.

For example, assume that a company with a weighted average cost of capital (WACC) of 10% is comparing two projects, A and B. Project A has a NPV of $3 million and an estimated life of five years, while Project B has a NPV of $2 million and an estimated life of three years. Using a financial calculator*, Project A has an EAA of $791,392.44, and Project B has an EAA of $804,229.61. Under the EAA approach, Project B would be selected since it has the higher equivalent annual annuity value.

The EAA approach is relatively easier to use rather than the other method used to compare projects with unequal lives, the replacement-chain or common life approach.

*Note: Most financial calculators would use the following inputs:

Project A – N (project life) = 5, i (WACC) = 10%, PV = -3,000,000, FV = 0, compute PMT (the answer should be 791,392.44).

Project B – N (project life) = 3, i (WACC) = 10%, PV = -2,000,000, FV = 0, compute PMT (the answer should be 804,229.61).

  1. Discounted Cash Flow (DCF)

    Discounted cash flow (DCF) is a valuation method used to estimate ...
  2. Weighted Average Cost Of Capital ...

    Weighted average cost of capital (WACC) is a calculation of a ...
  3. Internal Rate Of Return - IRR

    A metric used in capital budgeting measuring the profitability ...
  4. Net Present Value - NPV

    Net Present Value (NPV) is the difference between the present ...
  5. Annuity

    A financial product that pays out a fixed stream of payments ...
  6. Cost Of Capital

    The required return necessary to make a capital budgeting project, ...
Related Articles
  1. Active Trading

    Evaluate Stock Price With Reverse-Engineering DCF

    This is a more accurate method to use when trying to find a target price for a stock.
  2. Investing Basics

    DCF Valuation: The Stock Market Sanity Check

    Calculate whether the market is paying too much for a particular stock.
  3. Options & Futures

    Find Investment Quality In The Income Statement

    Use these key attributes to uncover top-level investments.
  4. Forex Education

    Understanding The Income Statement

    Learn how to use revenue and expenses, among other factors, to break down and analyze a company.
  5. Fundamental Analysis

    Top 3 Pitfalls Of Discounted Cash Flow Analysis

    The DCF method can be difficult to apply to real-life valuations. Find out where it comes up short.
  6. Investing

    Peer Comparison Uncovers Undervalued Stocks

    Learn how to put one of the top equity analysis tools to work for you.
  7. Economics

    What Happens in a Make-or-Buy Decision?

    A make-or-buy decision happens when a company must choose to either manufacture an item itself, or buy it premade from a supplier.
  8. Investing Basics

    What Does In Specie Mean?

    In specie describes the distribution of an asset in its physical form instead of cash.
  9. Economics

    Calculating Days Working Capital

    A company’s days working capital ratio shows how many days it takes to convert working capital into revenue.
  10. Economics

    Calculating Cross Elasticity of Demand

    Cross elasticity of demand measures the quantity demanded of one good in response to a change in price of another.
  1. Can I borrow from my annuity to put a down payment on a house?

    You can borrow from your annuity to put a down payment on a house, but be prepared to pay an assortment of fees and penalties. ... Read Full Answer >>
  2. What are the main kinds of annuities?

    There are two broad categories of annuity: fixed and variable. These categories refer to the manner in which the investment ... Read Full Answer >>
  3. What are the risks of rolling my 401(k) into an annuity?

    Though the appeal of having guaranteed income after retirement is undeniable, there are actually a number of risks to consider ... Read Full Answer >>
  4. How do I get out of my annuity and transfer to a new one?

    If you decide your current annuity is not for you, there is nothing stopping you from transferring your investment to a new ... Read Full Answer >>
  5. What are the biggest disadvantages of annuities?

    Annuities can sound enticing when pitched by a salesperson who, not coincidentally, makes huge commissions selling them. ... Read Full Answer >>
  6. What are the risks of annuities in a recession?

    Annuities come in several forms, the two most common being fixed annuities and variable annuities. During a recession, variable ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Gross Profit

    A company's total revenue (equivalent to total sales) minus the cost of goods sold. Gross profit is the profit a company ...
  2. Revenue

    The amount of money that a company actually receives during a specific period, including discounts and deductions for returned ...
  3. Normal Profit

    An economic condition occurring when the difference between a firm’s total revenue and total cost is equal to zero.
  4. Operating Cost

    Expenses associated with the maintenance and administration of a business on a day-to-day basis.
  5. Cost Of Funds

    The interest rate paid by financial institutions for the funds that they deploy in their business. The cost of funds is one ...
  6. Cost Accounting

    A type of accounting process that aims to capture a company's costs of production by assessing the input costs of each step ...
Trading Center
You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!