Chapter 4 (Cont.

)
ALTERNATIVE SELECTION
BY
ANNUAL WORTH ANALYSIS

Advantages of Annual Worth

Popular Analysis Technique
Easily understood results are reported in $
/ time period
Eliminates the LCM problem associated
with the present worth method
Only have to evaluate one life cycle of a
project
3

Annual Worth Calculations

Generally,
A = P(A/P, i%, n)
A = F(A/F, i%, n)

Convert all cash flows to their end of period

equivalent amounts
For comparison, in Example 5.2 about office lease
options, a P analysis was performed over 18 years, the
LCM of 6 and 9 years.
4

Present Worth Example: Unequal lives

A project engineer is assigned to start up a new office in a

city where a 6-year contract has been finalized. Two lease
options are available, each with a first cost, annual lease
cost, and deposit-return estimates shown below.

Determine which lease option should be selected on

the basis of a present worth comparison, if the MARR
is 15% per year.
5

 Comparison must be made over equal time periods;

Compare over the least common multiple, LCM.
Since the leases have different terms (service lives),
compare them over the LCM of 18 years.
For life cycles after the first, the first cost is repeated in year
0 of each new cycle, which is the last year of the previous
cycle. These are years 6 and 12 for location A and year 9
for B.
The cash flow diagram is in Figure 52.
Calculate PW at 15% over 18 years.
6

PA = -15,000 14,000 (P/F, 0.15, 6) 14,000 (P/F, 0.15, 12) + 1000 (P/F, 0.15, 18) 3,500(P/A, 0.15,18)
= -15,000 14000 (0.4323) 14000 (0.1869) + 1000 (0.0808) - 3,500 (6.1280)
= - 45036 + 80.80 = - $45,036
PB = -18,000 - 16,000 (P/F, 0.15, 9) +2,000 (P/F, 0.15, 18) - 3,100(P/A, 0.15, 18)
= -18,000 - 16,000 (0.2843) + 2,000 (0.0808) - 3,100(6.1280)
= -$41,384
Location B is selected, since it costs less in PW terms;

Consider only location A with a 6-year life cycle.

The cash flow diagram shows the cash flows for the
3 life cycles (first cost $15,000; annual costs $3500;
deposit return $1000). Demonstrate the equivalence
(at i = 15%) of P over 3 life cycles and A over one
cycle. In the previous example, present worth for
location A was calculated as P = -$45,036.

Calculate the equivalent uniform annual worth value for all cash flows in the first
life cycle.
A = -15,000(A/P,15%,6) +1000(A/F,15%,6) 3500 = - $7349

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

A = - 45,036 (A/P,15%,18)
A = - 45,036 (0.16139) = - $7349.42

10

AW and Repeatability Assumption

If two or more alternatives possess unequal
lives then evaluate the AW for any given cycle
The annual worth of one cycle is the same as
the annual worth of the other cycles (by
assumption)

11

Capital Recovery and AW Values

Assume the potential purchase of any productive
asset
One needs to know or estimate:
Initial Investment - P
Estimated Future Salvage Value - S
Estimated life of the asset - N
Estimated operating costs and timing
Operative interest rate i%

12

CAPITAL RECOVERY COST (CR)

CR = the equivalent annual worth of the asset
given:
S
F
N

.
0

N-1

P0

Capital Recovery (CR) is the annualized equivalent of the initial

investment, P0 and the annualized amount of the future salvage
value Fn
13

14

The cash flows for the tracker system must be converted to an equivalent AW cash flow
sequence over 8 years. The AOC is A = -$0.9 per year, and the capital recovery is
calculated by using Equation [6.3]. The present worth P in year 0 of the two separate
investment amounts of $8 and $5 is determined before multiplying by the A/P factor.

The correct interpretation of this result is very important to Lockheed Martin. It

means that each year for 8 years, the equivalent total revenue from the tracker
must be at least $2,470,000 just to recover the initial present worth investment plus
the required return of 12% per year.
This does not include the AOC of $0.9 million each year.
A = - 2.47 - 0.9 = $3.37 million per year
15

The owner of PizzaRush.com plans to purchase and install 5 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 Los Angeles area. The

expected result is faster, friendlier service to customers, and more income for
PizzaRush.

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 $650 for
the first year, increasing by $50 per year thereafter. The MARR is 10%.
Perform an annual worth evaluation that answer the following questions:

16

A = - capital recovery + equivalent net income

CR = - 5(4600)(A/P,10%, 5) + 5(300)(A/F,10%, 5) = -$5822
A = - 5(4600)(A/P,10%, 5) - 650 + 5(300)(A/F,10%, 5) - 50
(A/G,10%, 5)
A = - 5(4600)(0.2638) - 650 +5(300)(0.1638) - 50 (1.8101) =
-$6562.21

 (b) The owner conservatively estimates increased income of $1200 per

year for all five systems. Is this project financially viable at the MARR?
The financial viability can be determined without calculating the AW
value. The $1200 in new income is substantially lower than the CR of
$5822 that does not yet include the annual costs. The purchase is
clearly not economically justified.
The annual operating costs and incomes form an arithmetic gradient
series with a base of $550 ($1200 $650) in year 1, decreasing by $50
per year for 5 years. The AW relation is:

A = - capital recovery + equivalent net income

= -5822 + 550 - 50(A/G,10%,5) = -$5362
This is the equivalent 5-year net amount needed to return the investment and recover
the estimated operating costs at a 10% per year return. This shows, that the
alternative is clearly not financially viable at MARR = 10%. Note that the estimated
extra $1200 per year income, offset by the operating costs, has reduced the required
18
annual amount from $5822 to $5362.

Annual Worth of a Permanent Investment

This section discusses the annual worth equivalent of the capitalized
cost.
Evaluation of public sector projects (flood control dams, irrigation
canals, bridges, or other large-scale projects), requires the comparison
of alternatives that have such long lives that they may be considered
infinite in economic analysis terms.
For this type of analysis, the annual worth of the initial investment is the
perpetual annual interest earned on the initial investment, that is,
CR = A = Pi.
This is Equation [5.3]; however, the A value is also the capital recovery
amount.
19

The U.S. Bureau of Reclamation is considering three proposals for increasing the
capacity of the main drainage canal in an agricultural region of Nebraska.
Proposal AA requires dredging the canal to remove 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 annual operating costs are
estimated to total $50,000. To control 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.
Proposal BB is to line the canal with concrete at an initial cost of $4 million. 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 CC is to construct a new pipeline along a different route. Estimates
are: an initial cost of $6 million, annual maintenance of $3000 for right-of-way,
and a life of 50 years.
Compare the alternatives on the basis of AW , using an i= 5% per year.
20

CR = A = Pi.
21