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:


  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).



comments powered by Disqus
Hot Definitions
  1. Federal Reserve Note

    The most accurate term used to describe the paper currency (dollar bills) circulated in the United States. These Federal Reserve Notes are printed by the U.S. Treasury at the instruction of the Federal Reserve member banks, who also act as the clearinghouse for local banks that need to increase or reduce their supply of cash on hand.
  2. Benchmark Bond

    A bond that provides a standard against which the performance of other bonds can be measured. Government bonds are almost always used as benchmark bonds. Also referred to as "benchmark issue" or "bellwether issue".
  3. Market Capitalization

    The total dollar market value of all of a company's outstanding shares. Market capitalization is calculated by multiplying a company's shares outstanding by the current market price of one share. The investment community uses this figure to determine a company's size, as opposed to sales or total asset figures.
  4. Oil Reserves

    An estimate of the amount of crude oil located in a particular economic region. Oil reserves must have the potential of being extracted under current technological constraints. For example, if oil pools are located at unattainable depths, they would not be considered part of the nation's reserves.
  5. Joint Venture - JV

    A business arrangement in which two or more parties agree to pool their resources for the purpose of accomplishing a specific task. This task can be a new project or any other business activity. In a joint venture (JV), each of the participants is responsible for profits, losses and costs associated with it.
  6. Aggregate Risk

    The exposure of a bank, financial institution, or any type of major investor to foreign exchange contracts - both spot and forward - from a single counterparty or client. Aggregate risk in forex may also be defined as the total exposure of an entity to changes or fluctuations in currency rates.
Trading Center