When we buy any business asset or construct it, our first question will be in our mind, whether, we can pay its annual cost or not? I can take your personal example. For example, you have bought a Car for your personal use. It is your first question, whether you can pay its annual cost or not. For this, you need to calculate its annual cost. You can estimate total petrol cost. You can calculate total value of annual depreciation. You can calculate total value of its annual repair. You can calculate its total value of annual insurance. But in business, there are lots of fixed assets. Above method is time consuming. So, we will estimate the annual cost on the basis of equivalent annual cost method.
Definition of Equivalent annual cost
Equivalent annual cost is per year cost of any asset whether you will use or not. If we divide net present value with present value of annuity factor, we can calculate it. It is the tool of capital budgeting. We will buy that fixed asset whose per year EAC will be minimum. For choosing better fixed asset out of two or more fixed asset, we will analyze their NPV, time period of asset and present value of annuity factor.
On this calculation, we can also decide :
a. Which is better : To buy the fixed asset or to get it on lease.
b. How much investment need for getting minimum EAC. For example, if we buy old car, its life is less and EAC will be high than EAC of new car because its active life is more than old car.
Formula of Calculating EAC
Simple Formula of EAC = Net present Value / Present value of Annuity factor
Annuity factor = 1 – 1/(1+ cost of capital)^time/ cost of capital
Annuity factor = 1-1/(1+r)^t/r
This technique of capital budgeting had first used in 1923. These days, accountant prefers NPV technique instead of EAC.