On the Equivalent Annual Cost Method

Abstract

The equivalent annual cost (EAC) method is a useful tool in asset pricing, lease financing and corporate investment. It deals with projects with different economic lives and has wide applications in many fields outside the finance or even business. However, the important EAC concept and its applications are not always very well understood even within the finance academia. There are a few misunderstandings surrounding 1this widely taught and practiced methodology as evidenced by our experience with finance professionals over the past decades and the lack of clarity in all the mainstream textbooks we have surveyed. One of them is the misconception that the EAC method requires infinite time horizon and infinite repetitions of the identical project or equipment. Given its importance and wide application, the finance profession has an obligation to serve well its gatekeeper role by not overlooking these misconceptions. Thus far, no one has raised and addressed these misconceptions. We fill in this void by explicitly revealing, explaining and addressing these misconceptions. Specifically, we argue that infinite horizon is a convenience but not a necessity by showing how the method can be used for projects or assets with finite horizons and what cautions one has to take. We also provide threads for future studies along this line. Our work makes a marginal contribution the finance theory, pedagogy and practice.