Equivalent Annual Annuity Approach - EAA

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DEFINITION

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

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).




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