EQUIVALENT, INCIDENTAL AND INCREMENTAL CASH FLOWS

Howard Qi
Michigan Technological University
Yan Alice Xie
University of Michigan at Dearborn
ABSTRACT
The equivalent annuity cash flow (EACF) method is an interesting concept in asset pricing
and corporate finance. It is normally believed that the EACF applies in cases where the cash flows
of certain pattern repeat themselves perpetually. However, the authors of this study clarify that this
is not a necessary condition of the equivalent annuity cash flow method. The method’s simple
appearance belies several subtleties that could easily invalidate the method without causing any
alarm. This study explains how to apply this methodology to finite horizons, especially when the
projects have different economic lives, and how the issues of incidental and incremental cash flows
may arise and be correctly handled in the EACF framework. A search of the literature suggests that
this is the first study to address these issues. Given the importance of the EACF methodology to both
theorists and practitioners, the authors make a marginal yet important contribution to the literature
in clarifying the EACF concept and methodology.