Chapter #6

ISYE 220 Engineering Economy
Spring 2014
Chapter 6
Annual Worth Analysis!
Chapter #6 - Overview
Advantages of Annual Worth
Capital Recovery and AW Values
AW Analysis
Perpetual Life
Life-Cycle Cost (LCC) Analysis
Principle: Measure investment worth on annual
basis
Benefit: By knowing annual equivalent worth, we
can:
Seek consistency of report format
Determine unit cost (or unit profit)
Facilitate unequal project life comparison
Also known as equivalent annual worth (EWA), equivalent
annual cost (EAC), annual equivalent (AE) etc.
An alternative to Present Worth (PW) and Future Worth
(FW) analysis is Annual Worth (AW) analysis.
Annual worth analysis will select the same projects that
would be selected by PW or FW analysis.
The relationship between AW, PW and FW is:
AW = PW(A/Pin) = FW(A/F,i,n)
where n is the number of years in the planning horizon or
LCM used to obtain PW or FW.
Annual Worth (AW) analysis is often desirable since an
annual worth is often more intuitive to individuals who
think in terms of annual cash flows.

Example; dollars/year
Computing Equivalent Annual Worth!
$100
$50
$80
$120
$70
0
2 3 4 5 6
1
A = $46.07
2 3 4 5 6
1
AE(12%) = $189.43(A/P, 12%, 6)
= $46.07
$189.43
0
0
PW(12%) = $189.43
Annual Worth (AW) analysis is also desirable since AW has
to be calculated for only one life cycle. It is not necessary to
use LCM as we did for the PW and FW analyses.

When alternative have different lives, the AW method make
the following assumptions:
1. The services provided are needed for the indefinite
future (forever)
2. The selected alternative will be repeated for succeeding
life cycles in exactly the same manner as for the first life
cycle.
3. All cash flows will have the same estimated values in
every life cycle.

AW for one life cycle is the same for all life cycles!!

The major advantage of this method over all the other
methods is that it does not require making the
comparison over the least common multiple (LCM) of
years when the alternatives have different lives.

That is, the AW value of the alternative is calculated for
one life cycle only.

AW for one life cycle is the same for all life cycles!!

Repeating Cash Flow Cycles!
$500
$700
$800
$400 $400
$500
$700
$800
$400 $400
$1,000 $1,000
Repeating cycle
Repeating Cash Flow Cycles!
First Cycle:

PW(10%) = -$1,000 + $500 (P/F, 10%, 1)
+ . . . + $400 (P/F, 10%, 5)
= $1,155.68
AE(10%) = $1,155.68 (A/P, 10%, 5) = $304.87
Both Cycles:

PW(10%) = $1,155.68 + $1,155.68 (P/F, 10%, 5)
+ . . . + $400 (P/F, 10%, 5)
= $1,873.27
AE(10%) = $1,873.27 (A/P, 10%,10) = $304.87
Example #1!
An asset has a first cost of $20,000, an annual operating
cost of $8000 and a salvage value of $5000 after 3
years. Calculate the AW for one and two life cycles at i =
10%
Example #1 - SOLUTION!
years. Calculate the AW for one and two life cycles at i =
10%
AW
one
= - 20,000(A/P,10%,3) 8000 + 5000(A/F,10%,3)
AW
one
= $-14,532

AW
two
= - 20,000(A/P,10%,6) 8000 15,000(P/F,10%,3)
(A/P,10%,6) + 5000(A/F,10%,6)

AW
two
= $-14,532

Example #6.1 (from text)!
National Home-builders, Inc., evaluated cut and finish
equipment from Vendor A (6-year life) and Vendor B (9-
year life). The PW analysis used the LCM over 18 years.
Consider only the Vendor A option now. The cash flow
diagram shown is for all three life cycles (FC = $-15,000;
M&O costs = $-3500; Salvage Value = $1000).
Demonstrate the equivalence at i=15% of PW over three
life cycles and AW over one cycle. From the previous
example (#5.3) the present worth for Vendor A was
calculated as PW = $-45,036
Example #6.1 (from text) - SOLUTION!
AW
First cycle
= - 15,000(A/P,15%,6) 3500 + 1000(A/F,15%,6)
AW

= $-7349

AW

= PW(A/P, 15%, 18)
= -45,036(A/P, 15%, 18)
= $-7349
AW

= $-7349

Capital Recovery (CR) and AW Values!
Capital Recovery (CR) is the equivalent annual cost of
owning an asset plus the return on the initial investment.

Consider an alternative where P is the total of all initial
investments, A is the equivalent of all annual cash flows
(cost only in a service project, receipts and costs in
revenue projects), and S is the salvage value.

Then the relationship between CR and AW is:
AW = CR + A
where CR = -P(A/P,i,n) + S(A/F,i,n)

Annual Equivalent Cost!
When only costs are
involved, the AE
method is called the
annual equivalent cost.
Revenues must cover
two kinds of costs:
Operating costs and
Capital costs.
Capital
costs
Operating
costs
+
A
n
n
u
a
l

E
q
u
i
v
a
l
e
n
t

C
o
s
t
s

Annual Equivalent Cost!
Def: The cost of owning
an equipment is
associated with two
transactions(1) its
initial cost (I) and (2) its
salvage value (S).
Capital costs: Taking into
these sums, we calculate
the capital costs as:
0 1 2 3 N
0
N
I
S
CR(i)
CR(i) I(A/ P, i, N)+S(A/ F, i, N)
Example #1 - Continued!
CAPITAL COST CALCULATION!
years. Calculate the CAPITAL COST at i = 10%
Example #1 - Continued - SOLUTION!
CAPITAL COST CALCULATION!
cost of $8000 and a salvage value of $5000 after 3 years. Calculate the
CAPITAL COST at i = 10%
$20,000
$5,000
3
0
3 0 2 1
CR

= - 20,000(A/P,10%,3) + 5000(A/F,10%,3)
CR

= $-6532/year

AW = CR + A = $-6532 + $-8000 = $-14,532

Example #2!
You are evaluating the purchase of an income
property. You expect a MARR of 15%. What is the
Capital recovery and the Annual Worth?
75K Home
Purchase Price ($) $-15,000
Annual Maintenance ($/year) $-6,000
Annual Income ($/year) $7,500
Resale after expenses ($) $90,000
Life (years) 15
You are evaluating the purchase of an income property. You expect a MARR
of 15%. What is the Capital recovery and the Annual Worth?
75K Home
Purchase Price ($) $-15,000
Annual Maintenance ($/year) $-6,000
Annual Income ($/year) $7,500
Resale after expenses ($) $90,000
Life (years) 15
CR

= - 15,000(A/P,15%,15) + 90,000(A/F,15%,15)
CR

= $-673.50

AW = CR + A = $-673.50 + $1500 = $-826.50

Lockheed Martin is increasing its booster thrust power in
order to win more satellite launch contracts from
European companies interested in opening up new global
communication markets. A piece of earth-based tracking
equipment is expected to require an investment of $13
million, with $8 million committed now and the remaining
$5 million expected at the end of year 1 of the project.
Annual operating costs for the system are expected to
start the first year and continue at 0.9 million per year.
The useful life of the tracker is 8 years with a salvage
value of $0.5 million. Calculate the CR and the AW values
for the system, if the corporate MARR is 12% per year.
P = 8M + 5M(P/F, 12%, 1)
P = $12.46 M
CR = -12.46(A/P, 12%, 8) + 0.5(A/F, 12%, 8)
= -12.46(0.20130) + 0.5(0.08130)
CR = $-2.47 M
AW = CR + A = $-2.47 M + $-0.9 M = $-3.37 M

Capital Recovery (CR ) & AW Values!
Alternate Way!
(A/F, i, n) = (A/P, i, n) - I

CR = - P(A/P, i, n) + S[(A/P, i, n) -i]
CR = -[(P-S)(A/P, i, n) + S(i)]

Subtracting S from the initial investment P before applying
the A/P factor recognizes that the salvage value will be
recovered. This reduces CR, the annual cost of asset
ownership.
However, the fact that S is not recovered until year n of
ownership is compensated by charging the annual interest
s(i) against the CR.

Capital Recovery (CR ) & AW Values!
Spreadsheet Function!
General
=PMT(i%, n, P, F)

is written for CR as,

=PMT(i%, n, P, -S)

Evaluating Alternatives by Annual Worth
Analysis!
To evaluate alternatives:

First, calculate the AW at the MARR. For

One alternative:
If AW > 0, then the MARR is met or exceeded.

Two or more alternatives:
Select the alternative with the AW that is numerically the
largest, that is, less negative or more positive. This
indicates a lower AW of cost for cost alternatives or a
larger AW of net cash flows for revenue alternatives.
Analysis!
Example #3!
Evaluate the purchase of a new or used car that needs
to last you for 10 years. MARR = 8%.
New Car Used Car
Purchase Price ($) $-20,000 $-10,000
Annual Maintenance ($/year) $-750 $-1000
Resale Value ($) $4,000 $4,000
Life (years) 10 5
Analysis!
Evaluate the purchase of a new or used car that needs to last you for 10 years. MARR = 8%.
New Car Used Car
Purchase Price ($) $-20,000 $-10,000
Resale Value ($) $4,000 $4,000
Life (years) 10 5
AW(new) = -$20,000(A/P,8%,10) -$750 + $4000(A/F,8%,10)
AW(new) = -$3454.48
PW(new) = -20,000 - 750(P/A, 8%,10) + 4000(P/F,8%,10)
PW(new) = $-23,179.78
AW(new) = PW(A/P, 8%,10) = -$3454.48
Analysis!
Evaluate the purchase of a new or used car that needs to last you for 10 years. MARR = 8%.
New Car Used Car
Purchase Price ($) $-20,000 $-10,000
Resale Value ($) $4,000 $4,000
Life (years) 10 5
AW(used) = -$10,000(A/P,8%,5) - $1000 + $4000(A/F,8%,5)
AW(used) = -$2822.76
PW(used) = -10,000 -1000(P/A, 8%,10) -6000(P/F,8%,5)
+ 4000(P/F,8%,10) = $-18,940.9
AW(used) = PW(A/P, 8%, 10) = -$2822.76
Analysis!
Heavenly Pizza, which is located in Toronto, fares very well
with its competition in offering fast delivery. Many students at
the area universities and community colleges work part-time
delivering orders made via the web. The owner, Jerry, a
software engineering graduate, plans to purchase and install
five portable, in-car systems to increase delivery speed and
accuracy. The systems provide a link between the web-order
placement software and the On-star system for satellite-
generated directions to any address in the area. The expected
result is faster, friendlier service to customers and larger
income.
Analysis!
Each system costs $4600, has a 5-year useful life, and may be
salvaged for an estimated $300. Total operating cost for all
systems is $1000 for the first year, increasing by $100 per year
thereafter. The MARR is 10%. Perform an annual worth
evaluation for the owner that answers the following questions.
Perform the solution by hand and spreadsheet.
(a) How much new annual net income is necessary to recover the
investment at the MARR of 10% per year?
(b) Jerry estimates increased net income of $6000 per year for all
five systems. Is this project financially viable at the MARR?
(c) Based on the answer in (b), determine how much new net
income Heavenly Pizza must have to economically justify the
project. OC remain as estimated.
Analysis!
(a) Five portable systems:
CR = - 5(4600(A/P, 10%, 5)) + 5(300(A/F, 10%, 5))
CR = $-5822
The five systems must generate an equivalent annual
new revenue of $5822 to recover the initial investment
plus a 10% per year return
Analysis!
(b) Five portable systems:
AW = CR + A
= CR + (5000) -100(A/G, 10%, 5)
AW = -5822 + 5000 - 100(A/G, 10%, 5)
AW = $-1003
The system is not financially justified at the net income
level of $6000 per year.
Analysis!
(c) Let the net income = R then setting AW = 0, we get R
AW = CR + A
0 = -5822 + (R-1000) -100(A/G, 10%, 5)
0 = -5822 - 1000 + R - 100(A/G, 10%, 5)
R = $7003 per year
The system is to be financially justified!
Analysis!
Analysis!
Analysis!
AW of a Permanent Investment!
For a permanent investment with an initial
investment of P, the capital recovery is simply the
annual interest earned, in other words:

CR = Pi

In addition, to find the annual worth, all cash flows
must be converted to equivalent annual amounts,
A.
Then, AW = CR + A
Example #4!
A toll-road was just completed at a cost of $1.5 billion,
with major maintenance expenditures of $500 million
forecast every 10 years. Annual receipts minus
maintenance results in a positive cash flow of $150
million. What is the annual worth, assuming i = 5%?
$150
0 1 2 3 4 5 6 7 8 9 10 11 20
$150
$500
$1500
$500
$150
A toll-road was just completed at a cost of $1.5 billion, with major maintenance
expenditures of $500 million forecast every 10 years. Annual receipts minus
maintenance results in a positive cash flow of $150 million. What is the annual
worth, assuming i = 5%?
$150
0 1 2 3 4 5 6 7 8 9 10 11 20
$150
$500
$1500
$500
$150
CR = $1500 * .05 = $75 million
AW = -$75 + 150 - $500(A/F,5%,10) = $35.25 million
Example #5!
Select the best alternatives using AW and i = 10%
per year for the choices shown below;

A B
First Cost ($) $-50,000 $-250,000
Annual Operating Cost ($/year) $-20,000 $-9000
Salvage Value ($) $5,000 -
Life (years) 5
Select the best alternatives using AW and i = 10% per year for the choices shown below;

AW
A
= -50,000(A/P,10%,5) 20,000 + 5,000(A/F,10%,5)
= $-32,371
AW
A
= $ -32, 371

AW
B
= Pi + AOC = -250,000(0.10) 9,000
= $-34,000
AW
B
= $ -34, 000

A B
First Cost ($) $-50,000 $-250,000
Annual Operating Cost ($/year) $-20,000 $-9000
Salvage Value ($) $5,000 -
Life (years) 5
Example #6.5!
The U.S Bureau of Reclammation is considering three proposals
for increasing the capacity of the main drainage canal in an
agricultural region of Nebraska. Proposal A requires dredging
the canal to remove the sediment and weeds that have
accumulated during previous years operation. The capacity of
the canal will have to be maintained in the future near its
design peak flow because of increased water demand. The
Bureau is planning to purchase the dredging equipment and
accessories for $650,000. The equipment is expected to have a
10-year life with a $17,000 salvage value. The AOC are
estimated to total $50,000. To control the weeds in the canal
itself and along the banks, environmentally safe herbicides will
be sprayed during the irrigation season. The yearly cost of the
weed control program is expected to be $120,000.
Example #6.5!
Proposal B is to line the canal with concrete at an initial cost of
$4M. The lining is assumed to be permanent, but minor
maintenance will be required every year at a cost of $5000. In
addition, lining repairs will have to be made every 5 years at a
cost of $30,000.

Proposal C is to construct a new pipeline along a different
route. Estimates are an initial cost of $6M, annual maintenance
of $3000 for right-of-way and a life of 50 years.

Compare the alternatives based on the basis of annual worth,
using an interest rate of 5% per year!
Example #6.5 - SOLUTION!
Proposal A Proposal B Proposal
C
Initial Investment ($) $-650,000 $-4M $-6M
Annual
Operating/Maintenance Cost
($/year)
$-50,000 $-5000 $-3000
Other Recurring Costs ($) $-120,000/year
(Weed Control)
$-5000 every 5 yrs
(Lining repair)
-
Salvage Value ($) $17,000 - -
Life (years) 10 50
Proposal A
CR for dredging equipment:
-650,000(A/P,5%,10)+17,000(A/F,5%,10) $-82,824
Annual Cost for Maintenance $-50,000
Annual Cost for Weed Control $-120,000
TOTAL ANNUAL WORTH $-252,824
Proposal B
CR of initial investment: -4M(0.05) $-200,000
Lining repair Cost: -30,000(A/F,5%,5) $-5429
Proposal C
CR of pipeline: -6M(A/P,5%,50) $-328,680
Example #6.6!
At the end of each year, all owners and employees at Bell
County Cooperative are given a bonus check based on the
net profit of the Coop for the previous year. Bart just
received his bonus in the amount of $8530. He plans to
invest it in an annuity program that returns 7% per year.
Barts long-term plans are to quit the Coop job some years
in the future when he is still young enough to start his own
business. Part of his future living expenses will be paid from
the proceeds that this years bonus accumulates over his
remaining years at the Coop.
Example #6.6!

(a) Use spreadsheet to determine the annual amount
year-end withdrawal that he can anticipate (starting 1
year after he quits) that will continue forever. He is
thinking of working 15 or 20 more years.
(b) Determine the amount Bart must accumulate after 15
and 20 years to generate $3000 per year forever.
(a) F
after 15 yrs
= 8530(F/P,7%,15) = $23,534.27

A = P(i) = $23,534.27 * 0.07 = $1647 per year.

F
after 20 yrs
= 8530(F/P,7%,20) = $33008.541

A = P(i) = $33008.541 * 0.07 = $2311 per year.

(b) P = ?
P = A/i
= 3000/0.07 = $42,857
Bart must accumulate an amount of $42,857 to achieve his
goal of $3000 annual withdrawal.
To determine the number of years:
= NPER(7%,,8530,42857) = ~24 years

Life-Cycle Cost (LCC) Analysis!
Life-cycle - all the time from the initial conception
of an idea to the death of a product (process).
Life-cycle costs - sum total of all the costs
incurred during the life cycle.
Life-cycle costing - designing a product with an
understanding of all the costs associated with a
product during its life-cycle.
Life-cycle cost (LCC) analysis utilizes AW or PW
methods to evaluate the cost estimates for the entire
life-cycle of one or more projects.
Estimates will cover the entire life span from the early
conceptual stage, through the design and development
stages, throughout the operating stage and even the
phaseout and disposal stages.
Both direct and indirect costs are included to the
extend possible, and differences in revenue and savings
projections between alternatives are included.
Product-Life Cycle!
Product-Life Cycle!
Product-Life Cycle!
The three major phases are:
1. Acquisition Phase
a. Requirements definition phase
b. Preliminary design stage
c. Detailed design stage
2. Operation Phase
a. Construction and implementation stage
b. Usage stage
3. Phaseout and Disposal Phase
Example #6.7!
In the 1860s, General Mills (GM) Inc. and Pillsbury Inc.
both started in the flour business in the Twin cities of
Minneapolis-St. Paul, Minnesota. In the decade of 2000
to 2010, GM purchased Pillsbury for a combination cash
and stock deal worth more than $10B and integrated
the product lines. Food engineers, food designers and
food safety experts made many cost estimates as they
determined the needs of consumers and the combined
companys ability to technologically and safely produce
and market new food products. At this point only cost
estimates have been addressed - no revenues or profits.
Example #6.7!
Assume that the major cost estimates below have been
made based on a 6 month study about the two new
products that could have a 10-year life span for the
company. use LCC analysis at the industry MARR of 18%
to determine the size of the commitment in AW terms.
(Time is indicated in product-years. Since all estimates
are for costs, they are not preceded by a minus sign).
Determine PW by Phase and stage and then all add all
PW values and then determine AW for 10 years. Values
are in $1M units.
Acquisition Phase:
PW = $0.5 (Consumer study)
PW = 1.4(P/F,18%,1) (Design: Product and equipment)
PW = 1.5(P/A,18%,2) + 1.0(P/F,18%,2) (Design:
product and test marketing and equipment)

PW = $0.5 + $1.187 + $3.067 = $4.754M
Operation Phase:
Equipment and AOC:
PW = 2(P/A,18%,2) + 1.75(P/F,18%,2) + 2(P/F,18%,4)

+ 2.2(P/F,18%,8) +

Marketing:
PW = 8(P/F,18%,2) + [5(P/A,18%,8) -0.2(P/G,18%,8)]
(P/F,18%2)
PW = $20.144
0.2
1
1.04
1.18
8
0.14
P / F,18%, 2
( )
Operation Phase:
Human Resources (100 employees)(2000h/yr)($20/h)
= $4.0M in year 3

PW =

PW = $13.412

4.0
1
1.05
1.18
8
0.13
P / F,18%, 2
( )
Phaseout/Disposal stage:

PW = 1.0(P/A,18%,2)(P/F,18%,8) = $0.416

PW
TOTAL
= $45.238M

AW
TOTAL
= 45.238(A/P,18%,10) = $10.066 M/year


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