equivalent annual cost (EAC)

Calculating EAC – you are evaluating two different silicon wafer milling machines. The Techron I costs $270,000, has a three – year life, and has pretax operating costs of $45,000 per year. The Techron II cost $370,000, has a five – year life, and has pre tax operating costs of $48,000 per year. For both milling machine , use straight – line depreciation to zero over the project’s life and assume a salvage value of $20,000. If your tax rate is 35 percent and your discount rate is 12 percent, compute the EAC for both machine. Which do you prefer? Why?

We will need the after tax salvage value of the equipment to compute the EAC. Even though the equipment for each product has a different initial cost, both have the same salvage value. The after taxsalvage value for both is:

Both cases: aftertax salvage value = $20,000 (1-0.35) = $13,000

To calculate the EAC, we first need the OCF and NPV of each option. The OCF and NPV for Techron I  is:

OCF = - $45,000(1-0.35) + 0.35($270,000/3) = $2,250

NPV = -$270,000 + $2,250(PVIFA_12%,3) +($13,000/1.12³) = -$255,342.74

EAC = -$255,342.74 / (PVIFA _12%,3) = -$106,311.69

And the OCF and NPV for Techron II is:

OCF = -$48,000 (1 – 0.35) + 0.35 ($370,000/5) = - $5,300

NPV = -$370,000 - $5,300 (PVIFA_12%,5) + ($13,000/1.12⁵) = - $381,728.76

EAC = -$381,728.76 / (PVIFA_12%,5) = - $ 105,895.27

The two milling machines have unequal lives, so they can only be compare by expressing both on an equivalent annual basis, which is what the EAC method does. Thus, you prefer the Techron II because it has the lower (less negative) annual costs.

Reference: Corporate Finance Book, Stephen A.Ross, Randolph W.Westerfield and Jeffrey Jaffe, Ninth Edition. Chapter 5, questions number 10, page 196.