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Module 5: Annual Worth Analysis

SI-4251 Ekonomi Teknik


Muhamad Abduh, Ph.D.
Outline Module 5
 Selection of Alternatives with Different Lives
 Salvage Sinking-Fund Method
 Salvage Present Worth Method
 Capital-Recovery-Plus-Interest Method
 AW of a Perpetual Investment

2 SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.


Selection of Alternatives with Different Lives
1. Selection of investment alternatives can commonly evaluated by comparing
their equivalence-uniform-annual-worth (over the life of the investment)
2. Unlike other method, for evaluating alternatives with different lives, EUAW
does not require comparison over the least common multiple periods.

SV SV SV

O&M R R R R R R R R R
A
0 1 2 3
I I I

R R R I = Rp . 240 millions
I
B O&M O&M
R
=
=
Rp. 25 millions/month
Rp. 190 millions/4 months
SV = Rp 75 millions
0 1
SV

EUAW A = EUAW B
3 SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.
Example
 Consider a project with $3000 annual
operating cost and a $5000
investment required each 5 years. i
= 10%


0 1 2 3 4 5
 A 1-5 = $3,000
$5,000

For one cycle

 EAC = 3000 + 5000(A/P,10%,5) =


$4319/yr
4 SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.
Multiple cycle..same result!

0 1 2 3 4 5 6 7 8 9 10

A 1-10 = $3,000
$5,000

$5,000
Fo r tw o cycle s
E A C = 3 0 0 0 + 5 0 0 0 ( 1 + ( P |F , . 1 0 , 5 ))( A |P , . 1 0 ,
10)
= 3000 + 1319 = $ 4 3 1 9 / yr

5 SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.


(A) Salvage Sinking-Fund Method
1.Initial investment and salvage value are to
be converted into an equivalent uniform
annual value
2.Any other cash flows are to be converted
first to present value (P) or future value
(F), then converted into equivalent
uniform annual value
3.CombineP all equivalent
O1 uniform
I1
annual SV

valuesA1

0 1 2 3
EUAW = – P ( A / P , i , 36 ) + SV ( A / F , i , 36 ) – A1 – O 1 ( P / F , i , 9 )( A / P , i , 36 ) +
I 1 ( F / P , i , 14 )( A / F , i , 36 )
6 SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.
(B) Salvage Present Worth Method
1.Calculate the present worth of salvage value using
(P/F) factor, and subtract that value from the
initial cost, P
2.Convert that value (2) into equivalent uniform
worth
3.Any other cash flows are to be converted first to
present value (P) or future value (F), then
converted into equivalent uniform annual value
4.Combine P all equivalent
O1 uniform annual
I1 values SV

 A1

0 1 2 3
EUAW = – [ P - SV ( P / F , i , 36 )]( A / P , i , 36 ) – A1 – O 1 ( P / F , i , 9 )( A / P , i , 36 )
+ I 1 ( F / P , i , 14 )( A / F , i , 36 )
7 SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.
(C) Capital-Recovery-Plus-Interest Method
1. Subtract the salvage value from initial cost, then convert that
value into equivalent uniform worth
2. Multiply the salvage value by the interest rate
3. Add value obtained from (1) and (2)
4. Any other cash flows are to be converted first to present
value (P) or future value (F), then converted into
equivalent uniform annual value
5. Combine all equivalent uniform annual values
6.
 P O
I1 SV
1
A1

0 1 2 3
EUAW = – ( P - SV )( A / P , i , 36 ) - SV ( i ) – A1 – O 1 ( P / F , i , 9 )( A / P , i , 36 ) +
I 1 ( F / P , i , 14 )( A / F , i , 36 )
8 SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.
Example:

S = + $1500
 Cash Flow Diagram is:
A = +$1200/yr

1 2 3 4
5

-$650
-$700
-$750
P= -2 3 ,0 0 0 -$800
-$850

9 SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.


Example:
 The Capital Recovery component is:

S = + $1500

1 2 3 4
5

CR(10%) = -23,000(A/P,10%,5) +
1500(A/F,10%,5) = -$5822

P= -2 3 ,0 0 0

10 SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.


Example:
 (Revenue – Operating Costs) are:

A = + $ 1 2 0 0 /yr

1 2 3 4
5

$650
$700
$750
$800
$850

11 SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.


Example:
 Cost/Revenue component is seen to
equal:
1 .8 1 0 1

 =+550 –50(A/G,10%,5)
 = 550 – 90.50
 = $459.50

12 SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.


Example
 Total Annual worth (CR + Cost/Rev)
 CR(10%) = -$5822
 Revenue/Cost Annual amount: $459.50
 AW(10%) = -$5822+$459.50
 AW(10%) = $5,362.50

This amount would be required to recover the investment and operating


costs at the 10% rate on a per year basis

13 SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.


AW of a Perpetual Investment
 EAC of a perpetual investment

 If an investment has no finite cycle it is


called a perpetual investment. If “P” is
the present worth of the cost of that
investment, then EAC is P times i, the
interest P would have earned each year.

 EAC=A = P(i)
 Remember: P = A/i
From the previous chapter

14 SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.


Example: Perpetual Investment
 EXAMPLE
 Two alternatives are considered for
covering a football field.
 The first is to plant natural grass and
the second is to install AstroTurf. Interest
rate is 10%/year.
 Assume the field is to last a “long
time”.

15 SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.


Example: Continued

 Alternative A:

Natural Grass - Replanting will be
required each 10 years at a cost of
$10,000. Annual cost for maintenance
is $5,000. Equipment must be
purchased for $50,000 which will be
replaced after 5 years with a salvage
value of $5,000

16 SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.


Example: Natural Grass
Since cost is predominate, let (+) =
cost and (-) = salvage values

 Alternative A: F5 = $ 5 ,0 0 0 F5 = $5,000

0 1 2 3 4 5 6 7 8 9 10

A = $5,000

$ 1 0 ,0 0 0
F5=$50,000
P = $50,000+ $10,000
17 SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.
Example: Natural Grass: Analysis
 (+) $60,000(A/P,10%,10)
 (+) $5,000 (already an annual cost)
 (+) $50,000(P/F,10%,5)(A/P,10%,10)
 (-) $5,000(P/F,10%,5)(A/P,10%,10)
 (+) $10,000(A/F,10%,10)
 (-) $5,000(A/F,10%,10)
 = $ 19,046/year

18 SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.


Example: Artificial Carpet (Surface)

 A = P(i) for a perpetual life project


 Annual Cost of Installation:
 =$150,000 (.10) = $15,000/ year
 Annual Maintenance = $5,000/year

 Total: $15,000 + $5,000 = $20,000/Yr


 Choose A, cost less per year!

19 SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.


Comparing Alternatives by EUAW
Exercise:
Two types of production systems are being considered based on
interest rate of 9% and the following characteristics:

system A system B
Initial cost Rp 860.000.000,- Rp 1.360.
Annual O & M expenses Rp 89.000.000,- 000.000,-
Rp 73.000.000.-
Annual receipts Rp 121.500.000,- Rp 133.400.000,-
Salvage value Rp 200.000.000,- Rp 320.000.000,-
Life 6 years 10 years

(A/P, 9%, 6) = 0.21632 (A/P, 9%, 10) = 0.14903


(A/F, 9%, 6) = 0.13632 (A/F, 9%, 10) = 0.06903
(P/F, 9%, 6) = 0.60320 (P/F, 9%, 10) = 0.46320
20 SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.
Homework #5
1. A manufacturing company is trying to decide among three different pieces of
equipment that have the following characteristics:
2.
equipment A equipment B equipment C
3.
First cost Rp. 975.000.000,- Rp. 854.500.000,- Rp. 1.025.000.000,-
4.
Annual M&O cost Rp. 89.700.000,- Rp. 95.000.000,- Rp. 75.000.000,-
5.
Salvage value Rp. 161.000.000,- Rp. 205.000.000,- Rp. 321.000.000,-
6.
7. Overhaul cost Rp. 175.000.000,- / 2 Rp. 135.000.000,- / 3 Rp. 175.000.000,- / 3
years years years
 useful life = 6 years and interest rate of 12%
2. Which of these two machines that have the following costs is to be selected for
a continuous production process, if the i = 15% p.a:

machine X machine Y
2. First cost Rp. 3.800.000.000,- Rp. 1.675.000.000,-
Annual operating Rp. 289.700.000,- Rp. 315.000.000,-
3. cost
Salvage value Rp. 461.000.000,- Rp. 205.000.000,-
4. Life 5 years 3 years

5.
6.

21 SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.