Question

1. Why is the equivalent annual cost method potentially useful in decision making? Why would you use the real discount rate to compute the EAC? What problem(s) do you see with using the equivalent annual cost method to evaluate a company's options?

Answer 1

Equivalent annual cost method is used for capital budgeting decision making method in which, when there are various projects which will have unequal life then evaluation methods like net present value and internal rate of return aare not effective so equivalent annual cost method will be comparing the net present value and internal rate of return through assignment of an annual annuity and then the best project out of them is determined so equivalent annual cost method will be used to select various projects when there would be unequal lives between them.

I will be using the real discount rate to compute equivalent annual cost becausewe will have to consider the real cost of capital in order to assign individual risk to each project and derive the comparable value so we will be using the real discounting rate which will be the cost of capital for these kind of projects of unequal lives.We will be using separate cost of capital for each project in order to determine the risk associated with them and cash flows should be made equivalent and comparable

Problems which can be encountered in equivalent annual costing method while valuation of company will be as follows-

A. Equivalent annual costing method will be taking cost of capital for each project separately so it will be lengthier approach and and it cannot be adopted for each and every project so it will have very limited application.

B. Equivalent annual costing method is not as simple as NET present value or internal rate of return so it is a complex method in calculation of whether to invest in certain project or not.

so these are the problems that are associated with application of equivalent annual costing methods.