Equivalent Annual Annuity Approach (EAA)
Candlefocus EditorThe equivalent annual annuity calculator is used to compare cash flows from two or more projects and determines which project has the higher equivalent annual annuity. It does this by converting a series of future cash flows into a single benefits amount for each year. The project with the higher annual equivalent will usually be the best choice, depending on the investor’s risk profile.
The calculation of the equivalent annual annuity requires a few steps. The first step is to calculate the net present value (NPV) of each project. This is done by discounting all future cash flows (positive and negative) to their present value. The next step is to calculate the equivalent annual annuity amount for each project. This is done by dividing the NPV of each project by the number of years over which the project’s life is expected to last. This annualized amount indicates the net present value of the project after discounting for the size of the investment and the rate of return.
In addition to making capital budgeting decisions, the equivalent annual annuity approach can be used to evaluate financial instruments such as a bond or a loan. For example, an investor can use the approach to compare a 5-year bond paying 4% annually with a 7-year bond paying 5% annually. By calculating the equivalent annuity for each instrument, the investor can determine which bond has the highest required rate of return, and thus the best investment choice.
Overall, the equivalent annual annuity approach is a useful tool for investors and analysts making long-term decisions and trying to compare projects with unequal lives. It simplifies the comparison by reducing multiple cash flows over a project’s life to a single figure and it allows investors to compare the rate of return on different investments. Ultimately, the project with the highest equivalent annual annuity should be selected in order to ensure the highest rate of return with the lowest risk.