Equivalent Annuity Method

By: EconomyWatch   Date: 30 June 2010

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Capital budgeting is a decision making instrument which enables the management of a company to decide if taking on a new project is desirable. Before investing in any project, the advantages as well as the disadvantages are weighed. The returns on investment, one is likely to get is also calculated keeping in mind the effects of inflation. There are few, who believe that inflation does not affect capital budgeting because of inflation adjustments. In fact, inflation impacts cash flows as well as discount rates. All possible alternatives are adjudged. Investment appraisal is the other name for capital budgeting. There are four ways by, which capital budgeting is carried out.

They are:

  • Net present value, NPV
  • Internal rate of return, IRR
  • Modified internal rate of return, MIRR
  • Equivalent annuity method.

The Equivalent annuity method of capital budgeting is discussed in the following section:

Equivalent annuity method is also known as equivalent annual cash flow or equivalent annual annuity.The equivalent annuity method is employed to compare investment assignments, which are of unequal duration. This method is also used for evaluating the cost of those projects, having identical inflow of cash. If a particular assignment has a life span of 10 years and another project has a life span of 15 years, the two projects cannot be compared in terms of the net present value only. Any project, which assures greater returns than the other will usually be preferred. The equivalent annuity method is sometimes referred to as equivalent annual cost or EAC. The net present value or the NPV is expressed by the equivalent annuity method as annual cash flow divided by annuity factors 's present value.

Mathematically, the equivalent annuity method can be calculated by the formula:Equivalent annuity= (Cash flow as per present value)/ (Present Value Factor Of 'n' Year Annuity)

One should also keep in mind the other factors, which influence capital budgeting. In addition to mathematical calculations, involving net present values, discount rates, cash flow and several other internal as well as external forces of the company is to be taken into consideration.


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