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Chapter 6

Annual Worth
Analysis
Lecture slides to accompany

Engineering Economy
7th edition
Leland Blank
Anthony Tarquin

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Chapter 1
Economic measures of worth for cash flows
over a specific period.
Construction of cash flow diagram
Cash flow diagram;

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Chapter 2
Single amount factor;
Compound amount F/P
Present worth P/F

Factors for uniform series


Present worth P/A
Capital recover A/P

Compound amount

F/A
A/F

Sinking fund
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Chapter 3
Cash flow Series
Arithmetic gradient
Geometric gradient
To compute Present worth or Future worth
Present worth PG
Future worth FG
Shifted series
Present worth PG
Future worth FG
Effective interest rate
Continuous compounding
Interest rate vary over time
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Chapter 4
Nominal and effective interest rate
Account for compounding

Effective annual interest rate t = 1 year


Effective interest rate
Payment period and Compounding period
PP = CP
PP < CP
PP > CP
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Chapter 5
Present worth (PW) analysis
The present value of future amount of money (P/F)

Alternative proposals
Mutually exclusive alternative

Independent project

Present worth analysis


Equal life alternatives

Different life alternatives

Future worth analysis (FW)


Capitalized Cost analysis (CC)
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LEARNING OUTCOMES
1. Explain and compute AW
2. Compute Capital Recovery and
AW values
3. Perform AW analysis for one or
ME alternatives

4. Evaluate Perpetual life projects


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What is AW
AW is the equivalent annual worth of cash
flows of projects.
PW is the present worth, and
FW is the future worth

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Alternatives usually have the following


cash flow estimates
Initial investment, P

Salvage value, S
Annual amount, A
3,000
0

5,000

5,000

10,000

What is the PW, FW and AW if I = 10%?


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Relationship between PW, AW and FW


3,000
0

5,000

5,000

10,000

PW= -16,198
AW=
FW =

-9,333

-9,333
-19,600

PW = -10,000 - 5,000(P/F, 10%,1) - 2,000 (P/F,10%,2) =-16,198


AW = -10,000(A/P,10%,2) - 5,000 + 3,000(A/F,10%,2) = -11,668
FW = -10,000(F/P,10%,2) 5,000(F/A,10%,2) +3,000 = -25,600

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Calculation of Annual Worth


AW for one life cycle is the same for all life cycles!!
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%
AWone = - 20,000(A/P,10%,3) 8000 + 5000(A/F,10%,3)
= $-14,532
AWtwo = - 20,000(A/P,10%,6) 8000 15,000(P/F,10%,3)(A/P,10%,6)
+ 5000(A/F,10%,6)
= $-14,532
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Example 6-1
In Example 5.3, National Homebuilders, Inc. evaluated cut-andfinish equipment from vendor A (6-year life) and vendor B (9year life). The PW analysis used the LCM of 18 years. Consider
only the vendor A option now. The diagram in Figure 61 shows
the cash flows for all three life cycles (first cost $15,000; annual
M&O costs $3500; salvage value $1000).
Demonstrate the equivalence at i 15% of PW over three life
cycles and AW over one cycle. In Example 5.3, present worth
for vendor A was calculated as PW $45,036.

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Discussion Example 6-1

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Solution Example 6-1


Calculate the equivalent uniform annual worth value for all cash
flows in the first life cycle.
AW = -15,000( AP ,15%,6) -1000( AF ,15%,6) -3500 = - $7349

Now Equation [6.1] is applied to the PW value for 18 years.


AW = - 45,036( AP ,15%,18) = - $7349
The one-life-cycle AW value and the AW value based on 18 years are equal.

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Capital Recovery and AW


Capital recovery (CR) is the equivalent annual amount that
an asset, process, or system must earn each year to just
recover the first cost and a stated rate of return over its
expected life. Salvage value is considered when calculating
CR.

CR = -P(A/P,i%,n) + S(A/F,i%,n)
Use previous example: (note: AOC not included in CR )
CR = -20,000(A/P,10%,3) + 5000(A/F,10%,3) = $ 6532 per year
Now

AW = CR + A
AW = 6532 8000 = $ 14,532
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Example 6-2
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
communications 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 expended at the end of year 1 of the project. Annual
operating costs for the system are expected to start the fi rst
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 AW values for the system, if the corporate
MARR is 12% per year.
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Discussion Example 6-2

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Solution
Capital recovery: Determine P in year 0 of the
two initial investment amounts, followed by the
use of Equation [6.3] to calculate the capital
recovery. In $1 million units,
P = -8 -5( P/F ,12%,1) = -$12.46
CR = -12.46( A/P ,12%,8) + 0.5( A/F ,12%,8)
= -12.46(0.20130) + 0.5(0.08130)
= - $2.47
AW = -2.47 - 0.9 = - $3.37 million per year
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Selection Guidelines for AW Analysis


How do you make decision using AW analysis?

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ME Alternative Evaluation by AW
A company is considering two machines. Machine X has a first cost of
$30,000, AOC of $18,000, and S of $7000 after 4 years.
Machine Y will cost $50,000 with an AOC of $16,000 and S of $9000 after
6 years.
Which machine should the company select at an interest rate of 12%
per year?
Solution:

AWX = -30,000(A/P,12%,4) 18,000 +7,000(A/F,12%,4)


= $-26,412
AWY = -50,000(A/P,12%,6) 16,000 + 9,000(A/F,12%,6)
= $-27,052

Select Machine X; it has the numerically larger AW value


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Example 6-3
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.
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 fi rst 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 by spreadsheet.
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Example 6-3 (Continue)


(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 part ( b ), determine how much
new net income Heavenly Pizza must have to economically
justify the project. Operating costs remain as estimated.
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Discussion Example 6-3

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Example 6-3 Solution


a) The capital recovery amount calculated by
Equation [6.3] answers the fi rst question.
CR = -5[4600( A/P ,10%,5)] + 5[300( A/F ,10%,5)]
= -5[4600(0.26380)] + 5[300(0.16380)]
= - $5822
The five systems must generate an equivalent
annual new revenue of $5822 to recover the
initial investment plus a 10% per year return.
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Example 6-3 Solution


(b) Jerry estimates increased net income of $6000 per year for all five
systems. Is this project financially viable at the MARR?
(b) Figure 63 presents the cash flows over 5 years. The annual operating
cost series, combined with the estimated $6000 annual income, forms an
arithmetic gradient series with a base amount of $5000 and G $100. The
project is financially viable if
AW = 0 at i 10% per year.
Apply Equation [6.2], where A is the equivalent annual
net income series.
AW = CR + A = -5822 + 5000 -100( AG ,10%,5)
= - $1003

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Example 6-3 Solution


(c) Based on the answer in part ( b ), determine how much new net income Heavenly
Pizza must have to economically justify the project. Operating costs remain as
estimated.

Let the required income equal R, and set the


AW relation equal to zero to find the minimum
income to justify the system.
0 = 5822 + ( R - 1000) - 100( A/G ,10%,5)
R = 5822 -1000 - 100(1.8101)
= $7003 per year
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Solution (Spreadsheet)
MARR

10%

# of systems

Cost/system
Income/year

Year

(a) CR value

-4,600
$

6,000

Investment

Annual

Annual

and salvage

costs

income

Net income

-23,000

-23,000

-1,000

6,000

5,000

-1,100

6,000

4,900

-1,200

6,000

4,800

-1,300

6,000

4,700

1,500

-1,400

6,000

6,100

-5,822

(b) AW value

-1,003

= - PMT($B$2, 5, NPV($B$2,B10:B14)+B9)
= - PMT($B$2, 5, NPV($B$2,E10:E14)+E9)

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AW of Permanent Investment
Use A = Pi for AW of infinite life alternatives
Find AW over one life cycle for finite life alternatives

Compare the alternatives below using AW and i = 10% per year


C
D
First Cost, $
-50,000
-250,000
Annual operating cost, $/year
-20,000
-9,000
Salvage value, $
5,000
75,000
Life, years
5

Solution: Find AW of C over 5 years and AW of D using relation A = Pi


AWC = -50,000(A/P,10%,5) 20,000 + 5,000(A/F,10%,5)
= $-32,371
AWD = Pi + AOC = -250,000(0.10) 9,000
= $-34,000
Select alternative C
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Summary of Important Points


AW method converts all cash flows to annual value at MARR
Alternatives can be mutually exclusive, independent,
revenue, or cost
AW comparison is only one life cycle of each alternative
For infinite life alternatives, annualize initial cost as A = P(i)

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Assignments
Problems

6.4, 6.5, 6.8,


6.10,
6.13, 6.16,
6.23, 6.24, 6.29

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Question 6-4
James developed the two cash flow diagrams shown
at the bottom of this page. The cash flows for
alternative B represent two life cycles of A. Calculate
the annual worth value of each over the respective
life cycles to demonstrate that they are the same.
Use an interest rate of 10% per year.

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6.4
AWA = -5000(A/P,10%,3) - 25 + 1000(A/F,10%,3)
= -5000(0.40211) - 25 + 1000(0.30211)
= $-1733.44
AWB = -5000(A/P,10%,6) - 25 - 4000(P/F,10%,3)(A/P,10%,6) +
1000(A/F,10%,6)
= -5000(0.22961) - 25 - 4000(0.7513)(0.22961) + 1000(0.12961)
= $-1733.46
AW values are the same; slight difference due to round-off

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Question 6-5
An asset with a fi rst cost of $20,000 has an annual
operating cost of $12,000 and a $4000 salvage
value after its 4-year life. If the project will be needed
for 6 years, what would the market (salvage) value
of the 2-year-old asset have to be for the annual
worth to be the same as it is for one life cycle of the
asset? Use an interest rate of 10% per year.

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Solution 6-5
AW4 = -20,000(A/P,10%,4) 12,000 + 4000(A/F,10%,4)
= -20,000(0.31547) 12,000 + 4000(0.21547)
= $-17,448
-17,448 = -20,000(A/P,10%,6) 12,000 - (20,000
4000)(P/F,10%,4)(A/P,10%,6) + S(A/F,10%,6)
= -20,000(0.22961) 12,000 - (20,000 4000)(0.6830)(0.22961)
+ S(0.12961)
(0.12961)S = 1,653.38
S = $12,756
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Question 6-10
Ten years ago, Jacobson Recovery purchased a
wrecker for $285,000 to move disabled 18-wheelers.
He anticipated a salvage value of $50,000 after 10
years. During this time his average annual revenue
totaled $52,000. ( a ) Did he recover his investment
and a 12% per year return? ( b ) If the annual M&O
cost was $10,000 the fi rst year and increased by a
constant $1000 per year, was the AW positive or
negative at 12% per year? Assume the $50,000
salvage was realized.
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Solution 6-10
(a) CR = -285,000(A/P,12%,10) + 50,000(A/F,12%,10)
= -285,000(0.17698) + 50,000(0.05698)
= $-47,590 per year
At revenue of $52,000 per year, yes, he did
(b) AW = -285,000(A/P,12%,10) + 50,000(A/F,12%,10) +
52,000 - 10,000 -1000(A/G,12%,10)
= -285,000(0.17698) + 50,000(0.05698) + 42,000 1000(3.5847)
= $- 9,175 per year
AW was negative
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Polypropylene wall caps, used for covering exterior


vents for kitchen cooktops, bathroom fans, dryers,
and other building air exhausts, can be made by two
different methods. Method X will have a fi rst cost of
$75,000, an operating cost of $32,000 per year, and
a $9000 salvage value after 4 years. Method Y will
have a fi rst cost of $140,000, an operating cost of
$24,000 per year, and a $19,000 salvage value after
its 4-year life. At an interest rate of 10% per year,
which method should be used on the basis of an
annual worth analysis? 1-37

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Solution 6-13
AWX = -75,000(A/P,10%,4) 32,000 + 9000(A/F,10%,4)
= -75,000(0.31547) 32,000 + 9000(0.21547)
= $-53,721
AWY = -140,000(A/P,10%,4) 24,000 + 19,000(A/F,10%,4)
= -140,000(0.31547) 24,000 + 19,000(0.21547)
= $-64,072
Use Method X
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Question 6-23
The State of Chiapas, Mexico, decided to fund a
program for literacy. The first cost is $200,000 now,
and an update budget of $100,000 every 7 years
forever is requested. Determine the perpetual
equivalent annual cost at an interest rate of 10% per
year.

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Thank you

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