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WLC decision rules

Net Present Value (NPV) The most obvious decision approach is to base the choice on whole life costs as represented by the NPV of various competing alternatives. The NPV is defined as the sum of money that needs to be invested today to meet all future financial requirements as they arise throughout the life of the project. Obviously, the best alternative is the one with minimum NPV. As the WLC focuses on cost rather than income, it is usual practice to treat costs as positive and income as negative Equivalent Annual Cost (AEC) Rather than being expressed as a one-time net present value, this method converts all costs of an alternative to a uniform equivalent annual cost (EAC). The EAC is related to the NPV by the YP. In this way, alternatives with different lives can be compared without the need to attribute residual values. However, it should be noted that the EAC is an average number and does not indicate the actual cost that will be incurred during each year of the life cycle. The ranking criterion in this case is that the preferred alternative has the minimum EAC. AEC = NPV/YP

Discounting and Interest formula used in life cycle costing


1. Compound interest: This formula shows the future accumulated value of an initial capital. Compound interest = P x (1+ i) n Where P = principal or present value (e.g. initial capital); i= interest rate (as a decimal); n= time period (usually number of years) 2. Present Value: This formula shows the present value of a future accumulated amount. Present value of Rs.1 = A x 1 (1+ i) n Where A = accumulated amount; i= interest rate (as a decimal); n= time period (usually number of years) 1

3. Years purchase or Present value of Rs.1 payable at regular intervals: This formula shows the present value of an annual expenditure to take place over n number of years, Present value of Rs.1 per annum = R[ 1- (1+ i) -n ]

i
Where R = payments due at the end of each period (usually year); i= interest rate (as a decimal); n= time period (usually number of years) 4. Annuity purchased by Rs.1(Loan Repayment) = i(1+ i) n (1+ i) n -1 P=principal or present value (i.e. size of loan); i= interest rate (as a decimal); n= time period (usually number of years) 5. Sinking Fund: This formula shows the amount of money to be put aside each year to cover a future known expenditure. Sinking Fund = A x i

(1+ i) n - 1

6. Inflation Formula = (1+t) - 1 (1+f) This formula shows the discount rate to be applied which takes account of inflation, where t= actual discount rate (usually bank base rate), f=inflation rate. Note: to obtain a percentage the result from the formula has to be multiplied by 100 Life cycle costing can be used in value engineering to provide a meaningful comparison of the total cost of different design options. Anticipated future costs are converted to a common base by discounting future cash flows in order to identify the net present value (NPV) of each option. Example: Calculate the comparative Whole life costs of the following heating systems installations for a house. Basic Data System A System B 1,750 50 p.a 450(10th Yr) 750 15Yrs 250 7% 2

Initial purchase cost 1,500 Annual maintenance cost 50p.a th Pump replacement cost 400(8 Yr) Annual fuel cost 800 Time period of investment 15Yrs Expected residual value of investment 250 Interest rate 7%