How is the Equivalent Annual Cost (EAC) calculated?

The Equivalent Annual Cost (EAC) is calculated by taking the present value (PV) of the costs expected over the life of an asset and dividing it by the annuity factor. This method allows for the comparison of the cost-effectiveness of different projects or investments that may have different lifespans.

The calculation involves determining the total present value of costs (which could include initial capital costs, operating costs, maintenance costs, and any residual values), and then adjusting this figure to an annual basis using the annuity factor, which is derived from the discount rate and the number of periods in the asset's lifespan.

Using the annuity factor effectively spreads the total cost over its useful life, giving a consistent annual cost figure that can be easily compared across different alternatives. This analysis is particularly useful in capital budgeting and when deciding between projects that are not of the same duration.

The other choices do not provide the correct methodology for calculating EAC. For example, using the net income or total assets does not reflect cost efficiency related to capital investments. Additionally, dividing total costs by depreciation does not account for the time value of money, which is crucial in determining an asset’s cost over its useful life.