What is the equivalent annual annuity?
Equivalent Calculation of annual annuity (EAA) is used to evaluate investment projects that have uneven lives. If an investment analyst or portfolio manager compares two different investments with two different maturity data, this calculation can help determine a better investment opportunity. In general, investments are evaluated by comparing risk and return. Longer dated investments have a higher level of risk, as the investor's repayment takes longer. Therefore, it is important to take into account the length of the investment before making a final purchase decision.
If there are two different maturity for investment, it is difficult to compare return values, because longer -term securities are usually more risky. The equivalent annual annuity compares more opportunities with different maturity conditions by setting them all for one year. This means that the calculation translates the return to the equivalent annual rate, so all investments can be compared and assessed under the same conditions.
For example, if an investor has to choose between two investments worth $ 100,000 in the US (USD), they must know how long the two investments will provide value before the final decision. The first investment has a maturity of five years and the second investment has a maturity of two years. Since the second investment has shorter maturity, it is less risky and therefore provides a lower return rate. This determination is evident for investment with the same initial investment value, but becomes more demanding when these two amounts are not the same.
EAA calculation provides an analyst a way to compare different investment values with different time horizons by comparing the total cost. Investing with the lowest costs is a better solution. For example, if one investment has $ 5,000 measures and Another's investment has measures of $ 2,500, the other investment is a better solution because it has the lowest annual costs.
a real calculationEt is complex. These two variables are the current value of cash flows (PV) and the annual factor. Specifically, the EAA is calculated by division of PV by an ancite factor. The annuity factor is determined by the following formula: [1/r - 1/R (1+r)^t], where r is the rate of return or discount factor and t is a time period. Investments with a greater current value and/or the lowest annual factor will have the lowest costs.