Please explain a scenario in which the equivalent annual cost (EAC) approach would be a helpful approach to determining which project to choose. Additionally, please calculate the NPV for option A and option B. Which option would you use? (FINANCE 3400 CHAPTER 12)

FOR EXAMPLE: (GIVE A EXPLANATION LIKE THIS EXAMPLE)

Equivalent annual cost (EAC) is the annual cost of owning, operating, and maintaining an asset over its entire life.

EAC is often used by firms for capital budgeting decisions, as it allows a company to compare the cost-effectiveness of various assets that have unequal lifespans.

EAC allows managers to compare the net present values of different projects over different periods, to accurately determine the best option.

Example

Imagine that Company A is choosing between investing in two competing projects: Asset 1 and Asset 2. Asset 1 has an initial capital outlay of $100,000, an expected lifespan of 5 years, and annual maintenance expenses of $4,000. By contrast, Asset 2 has an initial capital outlay of $145,000, an expected lifespan of 8 years, and annual maintenance expenses of $2,500.

Essentially, youll need to divide the net present value (NPV) of the asset by the present value of an annuity factor:

Equivalent Annual Cost = NPV / A(t,r)

Where:

A(t,r) = (1 (1/(1+r)^t) / r

In this formula, r refers to the annual interest rate, while t refers to the number of periods. This can get somewhat complicated, which is why the standard equivalent annual cost formula simplifies the calculation. The formula is as follows:

Equivalent Annual Cost = (Asset Price x Discount Rate) / (1 (1 + Discount Rate)^-n)

In this equivalent annual cost formula, discount rate is the return thats necessary to make the project viable (also referred to as the cost of capital). n is the number of periods.

Assuming a 5% cost of capital, we can calculate the annuity factor like so:

Asset 1, A(t,r) = 1 (1 / 1 +0.05)^5 / 0.05) = 4.33

Asset 2, A(t,r) = 1 (1 / 1 +0.05)^8 / 0.05) = 6.46

Then, you can work out the equivalent uniform annual cost remembering to add on the annual maintenance cost:

Asset 1, EAC = ($100,000 / 4.33) + $4,000 = $27,094.69

Asset 2, EAC = ($145,000 / 6.46) + $2,500 = $24,945.82

As you can see, our equivalent annual cost analysis indicates that purely from a financial point of view Asset 2 is a better option as its EAC is considerably less than Asset 1.