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.
Investopedia explains 'Equivalent Annual Annuity Approach - EAA'
The EAA approach uses a three-step process to compare projects:
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).