Question

Does the Equivalent Annual Annuity (EAA) take into account the principle "money has a time value" and is it a discounting method or a non-discounting method?

Is it none of these?

Please explain your answer.

Answer 1

The equivalent annual annuity (EAA) approach is used in capital budgeting to compare mutually exclusive projects. The EAA approach discount the constant annual cash flow generated by a project over its lifespan. While comparing projects with computation of EAA, an investor should choose the one with the higher EAA.

EAA = (r x NPV) / (1 - (1 + r)^-n )

Where:

EAA = equivalent annual annuity

NPV = net present value of project

r = interest rate per period

n = number of periods

Therefore, we can see from above that Equivalent Annual Annuity (EAA) considers present value concept. Hence, we can say that EAA take into account the principle "money has a time value" and it is a discounting method. We need to compute each project's EAA so that the present value of the annuities is exactly equal to the project's NPV.