3360 Unit 06.2 2014-I-01

ENGR 3360U Winter 2014
Unit 6-2
Capital Recovery and Annual Worth
Dr. J. Michael Bennett, P. Eng., PMP,
UOIT,
Version 2014-I-01
Unit 6 Annual Cash Flow
Change Record
2014-I-01 Initial Creation
6-2
2014-I-01
Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco
Course Outline
1.
2.
3.
4.
5.
6.
7.
8.
9.
6-3
Engineering Economics
General Economics
1.
Microeconomics
2.
Macroeconomics
3.
Money and the Bank of
Canada
Engineering Estimation
Interest and Equivalence
Present Worth Analysis
Annual Cash Flow
Rate of Return Analysis
Picking the Best Choice
Other Choosing Techniques
2014-I-01
10. Uncertainty and Risk

11. Income and Depreciation
12. After-tax Cash Flows
13. Replacement Analysis
14. Inflation
15. MARR Selection
16. Public Sector Issues
17. What Engineering should know
about Accounting
18. Personal Economics for the
Engineer
Unit 6 Road Map

6.1 One Life Cycle
6.2 Capital Recovery and Annual Worth
6.3 Alternative Selections
6.4 Annual Worth of Permanent Investments
6.5 Salvage
6.6 Mortgages
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6.1 Advantages of Annual Cash Flow

Popular analysis technique
Easily understood -- results are reported in $

per time period, usually $ per year
Eliminates the LCM problem associated

with the present worth method
Only have to evaluate one life cycle
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Also Called EUA*

EUAC equivalent uniform annual cost
EUAB = benefits
EUAW =EUAB - EUAC
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AW Calculation from PW or FW
Computation from PW or FW
AW = PW(A/P, i%, n) or
AW = FW(A/F, i%, n)
AW converts all cash flows to their end of
period equivalent amounts in $ per year
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AW Value from Cash Flows

AW values can be calculated directly from
cash flows for only one life cycle
Not necessary to consider the LCM of lives
as is in PW or FW analysis
For alternative comparison, select the
alternative with the best AW value
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Example 6.1
Harry buys some furniture for $1,000. It should
last 10 years. At 7%, what is the AW?
AW = 1000(A/P, 7%, 10) = 142.40
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AW and Repeatability Assumption

If two or more alternatives have unequal life
estimates, only evaluate the AW for one life
cycle of each alternative
The annual worth of one cycle is the same as
the annual worth of all future cycles (from
repeatability assumption)
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Repeatability Assumption
Given alternatives with unequal lives, the
assumptions are:
1. The services provided are needed forever
2. The first cycle of cash flows is repeated for all successive
cycles in the same manner
3. All cash flows will have exactly the same estimated values in
every life cycle.
Note: The third assumption may be unrealistic in many
problems encountered in industry
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One or More Cycles

AW assumes repeatability of cash
flows
Cycle
1
Cycle
2
Cycle
k
Find the annual

worth of any given
cycle ($/period)
Annualize any one of the cycles
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6 Year & 12 Year Alternatives

For PW or FW analysis, need an 12 year study period
9 year Project
6 year Project
6 year Project
2 life cycles of the 6 year project

1 life cycles of the 12 year project
Means more calculation effort!
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Example 6.2 -- Using AW Analysis

If the cash flow patterns are assumed to remain the
same for the 6 and 12 year projects for future
cycles, then for AW method
Project A: 6 years
Project B: 12
Find the AW of any 6-year

cycle
Find the AW of any 12years
year cycle
Compare AWA value for 6 years with AWB

for 12 years to select the better
alternative
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Example 6.2
Two pumps are being considered with the
following specs.
PumpA
PumpB
Init cost
7,000
5,000
Salvage
1,500
1,000
Useful Life
12
6
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Compare
AW(pumpA)
= -7000(A/P, 7%, 12)+1500(A/F, 7%, 12)
= -881.3+83.9 = -797
AW (pumpB)
= -5000(A/P, 7%, 6) + 1000(A/F, 7%, 6)
= -909
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Advantages/Applications of AW
Applicable to a variety of engineering economy
studies such as:
6-17
Asset replacement
Breakeven analysis
Make-or-Buy decisions
Studies dealing with manufacturing costs
Economic value added (EVA) analysis
2014-I-01
6.2 Calculating Capital Recovery and AW

An economic alternative should have the following
cash flow estimates made
Initial investment -- P
Estimated future salvage value -- S
Estimated life -- n
Interest rate -- i% (this is usually the MARR)
Estimated annual operating costs AOC
Capital Recovery (CR) is the annualized equivalent of
the initial investment P and the future salvage
value S for n years at i%
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Capital Recovery Cost

It is important to know the equivalent annual
cost of owning an asset
This cost is called Capital Recovery or CR
CR is determined using {P, S, i, and n}
Estimated salvage
value at time n is S
0
...
n-1
P is initial purchase price at time 0

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Capital Recovery Cost

S
Given:
0
n
n-1
P
Convert to:
0
n
n-1
An amount of A per year (CR)

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Comparing CAPITAL RECOVERY with AW

CR is a cost, so it carries a negative sign
CR is the annual equivalent (an A value) that represents
the implied cost of an asset for n years at i% with a first
cost of P and a salvage value of S in year n
CR does NOT include annual operating costs, AOC
To obtain AW once CR is determined, calculate
AW = - CR - AOC
where AOC itself is an annual equivalent amount (same
each year)
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Capital Recovery Calculations

COMPUTING CR FOR INVESTMENTS WITH A SALVAGE VALUE
Method 1
Compute equivalent annual cost of the investment P
and subtract the equivalent annual savings of the
salvage value S. This is
P(A/P, i%, n) - S(A/F, i%, n)
Determine CR as the negative (cost) of this relation
CR = -[P(A/P, i%,n) - S(A/F, i%, n)]

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More Commonly Used CR Calculation

Method 2
Subtract salvage value S from original cost P and
calculate the equivalent annual cost of (P-S)
Add to that the interest which the salvage value would
return each year, S(i)
CR = -[(P - S)(A/P,i,n) + S(i)]

{-[P(A /P,i,n)-S(A/F,i,n)] and (A/P,I,n)=(A/F,i,n)+i so
{-[P(A/P,I,n)-[A/P,I,n)-Si] =-(P-S)(A/P,I,n)+Si]}
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CR Amount: What It Means

CR is the annual cost associated with owning a productive asset over n time
periods at interest rate i% per period
Equivalently, CR may be interpreted as the minimum amount of money an investment must earn
each of n years to recover the initial cost at a return of i%
Why? Remember, the purchase of assets to conduct

business involves a commitment of the owner's funds.
As such, an investment is a commitment of the owners
funds over n time periods. Thus, the owners expect a
return on that investment.
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6.3 Evaluating Alternatives Using AW

For mutually exclusive alternatives, select one
with lowest AW of costs(service) or highest
AW of net incomes (revenue)
This means, select the numerically largest AW
alternative
If AW < 0 at MARR, the (revenue) alternative is
not economically justifiable, since initial
investment P is not recovered over n years at
the required rate of MARR = i% per year
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Example 6.3
Telesats Anik-1 was the worlds first domestic communications
satellite when it was launched in 1972, bringing live broadcasts of
Hockey Night in Canada to northern communities. Fourteen
launches later in 2004, the Anik F2 was the first satellite to
commercialize the Ka frequency band for cost-efficient, twoway broadband services. Telesat is interested in a piece of Earthbased tracking equipment, which will require an investment of $13
million. Eight million dollars will be 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 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 AW value for the system, if the corporate MARR is currently
12% per year.
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Solution to 6.3
The cash flows for the tracker system must be
converted to an equivalent AW cash flow sequence
over 8 years. (All amounts are expressed in $1
million units.) The AOC is A = - $0.9 per year. 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.
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Cash Flow Diagrams a and b

0 1 2 3 4 5 6 7
8
$0.9
$5.0
$8.0
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(a)
2014-I-01
0 1 2 3 4 5 6 7
8
AW = $?
(b)
CR = -{[8.0 + 5.0(P/F, 12%, 1)](A/P, 12%, 8) 0.5(A/F, 12%, 8))}

= -{[12.46](0.2013) 0.040}
= $-2.47
The correct interpretation of this result is very important to Telesat. It means
that each and every 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. Since this amount, CR = $2.47 million,
is an equivalent annual cost, as indicated by the minus sign, total AW is
found; AW = -2.47 - 0.9 = $-3.37 million per year
This is the AW for all future life cycles of 8 years, provided the costs rise at the
same rate as inflation, and the same costs and services are expected to
apply for each succeeding life cycle.
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Example 6.4 PizzaButt

PizzaButt, a popular Oshawa pizza joint, competes well in the north end,
attracting many Durham and UOIT students. It also has an on-line
virtual store and delivers on demand, which the university kids really
like. It turns out that most students order the same pizza, pepperoni with
anchovies and shrooms. The owner, who coincidentally is taking ENGR
3360, wants to reduce delivery times by stocking the 5 cars with this
common pizza, aiming at grabbing market share by routing the web
orders through On-Star to the nearest pizza car on the road thus
delivering the pizza in super-fast times To effect this, she proposes
installing On-Star in all of her vehicles. On-Star will also give directions
to any location in the city. (On-Star is satellite wireless).
Each system costs $4,600, has a 5-year life cycle and may be salvaged
for $300. Total operating costs are $650 for the first year, increasing by
$50 per year thereafter. Assume that the MARR is 10%. The increased
income is assumed to be $1200/yr for all 5.
What is the CR and AW needed to recover this cost?
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PizzaButt Example
S=+
$1500
Cash Flow Diagram is:

A = +$1200/yr
1
5
-$650
-$700
-$750
P=23,000
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-$800
-$850
PizzaButt Example
The Capital Recovery component is:
S=+
$1500
1
CR(10%) = -23,000(A/P,10%,5) +
P=23,000
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1500(A/F,10%,5) = -$5822
PizzaButt Example
Cost/Revenue component is seen to equal:
=+1200 - 650 50(A/G,10%,5)
= 550 90.50
= $459.50
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(1.8101)
PizzaButt Example
(Revenue Operating Costs) are:
Annual Revenue = A = +$1200/yr

1
5
-$650
-$700
Annu
al
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-$750
Opera
ti
ng Co
-$800
sts
-$850
PizzaButt Answer
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 is a bad deal at 10% and/or an income

of + $1200. Question: what would you have
to make in additional profit for this to work?
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Special Cases for AW Analysis

If cash flow repeatability assumption cant
be made, specify a study period of n years
and perform analysis with this n in all
computations (Example 6.4(b) did this)
If projects are independent, select all with
AW > 0 at i = MARR, provided no budget
limit is defined.
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6.4 AW of a Permanent Investment

If an investment has no finite cycle (or a very long
estimated life) it is called a perpetual or permanent
investment
If P is the present worth of the cost of the investment,
then the AW value is P times i
AW =A = P(i)
AW is actually the amount of interest P would earn each year,
forever.
Remember: P = A/i
from the previous unit
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Example 6.5
A road must get past a mountain. There are 2
options: tunnel through the mountain or build
a road around it supported by concrete pillars.
The cost for the tunnel is $5.5M and the
useful life is infinite. The road would cost
$5M but only last 50 years. Assume 6%.
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Solution
Tunnel: A = Pi. So A = 5.5(0.06) = $330K
Road: A = 5(A/P,6%,50) = $317K
Select the road.
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6.5 Salvage Value

When there is a salvage value at the end of
the life of an asset, it is represented as a
one-time cash flow benefit at the end of the
assets life.
Example: Salvage valueS (S) of asset with a

4 year life
0
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Salvage Value, contd.

When there is an initial cost (P) followed by a salvage
value (S) the annual worth (AW) can be computed by:
AW = P(A/P, i, n) S(A/F, i, n)
OR
AW = (P S)(A/F, i, n) + Pi
OR
AW = (P S)(A/P, i, n) + Si
6-41
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6.6 Mortgages in Canada

The legal document:
Long term amortized loan that is used for buying property

If payments are not made, the lender can seize the property
and sell it to recover the debt
Legal document outlines the terms and conditions for
repayment of the loan (amortization period, interest rate,
penalties, etc.)
Amortization:
Length of time it takes to pay off loan assuming:
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Payments are made on time with no additional payments

Interest rate doesnt change
2014-I-01
Mortgages in Canada
Amortization periods are typically between:
5 years to 35 years
The norm is 20 or 25 years
Terms
6-43
A mortgage is often made up of smaller periods

called terms and a term is the period in which
the interest rate term is fixed.
At the end of the term, the mortgage can be
renewed for a another term at the current interest
rate.
2014-I-01
Types of Mortgages
Conventional:
For 75% or less of the appraised value
High-ratio mortgages:
Higher than 75% and usually require an outside

agency such as the CMHC (Central Mortgage
and Housing Corporation) to insure the mortgage.
Some Others:
6-44
Open, variable rate, ARM, capped rate,

convertible rate, second, reverse, and CHIP.
2014-I-01
Mortgage Equity and Interest Rates

Equity
The value remaining in a property after all mortgage and

loans registered against the title are subtracted from its
value.
Interest Rate
Interest rate is expressed as:
% compounded semi-annually, not in advance
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An old English term when ledgers were kept by hand

Nominal rate mortgage at 6% is actually 3% semi-annually
Summary
Unlike present worth analysis, annual cash
flow analysis does NOT require a common
analysis period between the alternatives.
However two assumptions are included:
That the actual values of future instances of a

service are the same as the current instance
There is a common multiple of useful lives
between the alternatives
As the value of n increases the capital recovery

factor approaches i.
6-46
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Summary, contd.
Mortgages in Canada are amortized over a
number of years.
There are a number of types of mortgages.
Equity:
The appraised property value value of

mortgage owing
Interest rate is traditionally stated as:
6-47
% compounded semi-annually, not in advance
2014-I-01
Chapter Summary cont.

AW method is often preferred to the PW method
AW deals with only one life cycle of an alternative
AW offers an advantage for comparing different-life
alternatives
Assumption for AW method: Cash flows in one
cycle are assumed to replicate themselves in
future cycles
For infinite life alternatives, simply multiply P by i
to get AW value
6-48
2014-I-01

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ENGR 3360U Winter 2014

Unit 6 Annual Cash Flow

Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 6 Annual Cash Flow

10. Uncertainty and Risk

Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 6 Annual Cash Flow

Unit 6 Road Map

Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 6 Annual Cash Flow

6.1 Advantages of Annual Cash Flow

Easily understood -- results are reported in $

Eliminates the LCM problem associated

Only have to evaluate one life cycle

Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 6 Annual Cash Flow

Also Called EUA*

Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 6 Annual Cash Flow

Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 6 Annual Cash Flow

AW Value from Cash Flows

Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 6 Annual Cash Flow

Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 6 Annual Cash Flow

AW and Repeatability Assumption

Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 6 Annual Cash Flow

Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 6 Annual Cash Flow

One or More Cycles

Find the annual

Annualize any one of the cycles

Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 6 Annual Cash Flow

6 Year & 12 Year Alternatives

2 life cycles of the 6 year project

Means more calculation effort!

Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 6 Annual Cash Flow

Example 6.2 -- Using AW Analysis

Find the AW of any 6-year

Compare AWA value for 6 years with AWB

Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 6 Annual Cash Flow

Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 6 Annual Cash Flow

Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 6 Annual Cash Flow

Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 6 Annual Cash Flow

6.2 Calculating Capital Recovery and AW

Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 6 Annual Cash Flow

Capital Recovery Cost

P is initial purchase price at time 0

Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 6 Annual Cash Flow

Capital Recovery Cost

An amount of A per year (CR)

Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 6 Annual Cash Flow

Comparing CAPITAL RECOVERY with AW