2/15/2023

EC 225
Engineering Economics

Annual Worth Analysis

Dr. Chetan Daté

Chapter 6

LEARNING OUTCOMES
1. Advantages of AW
2. Capital Recovery and AW values
3. AW analysis
4. Perpetual life | Long Life
5. Life-Cycle Cost analysis

©McGraw-Hill Education.

1
 2/15/2023

Alternatives usually have the following

cash flow estimates
Initial investment, P – First cost of an asset
Salvage value, S – Estimated value of asset at end of
useful life
Annual amount, A – Cash flows associated with asset, such as
annual operating cost (AOC), etc.

Relationship between AW, PW and FW

𝐀𝐖 = 𝐏𝐖(𝐀/𝐏, 𝐢%, 𝐧) = 𝐅𝐖(𝐀/𝐅, 𝐢%, 𝐧)
n is years for equal-service comparison (value of LCM or
specified study period)

©McGraw-Hill Education.

Advantages of AW Analysis

AW calculated for only one life cycle

Assumptions:
Services needed for at least the LCM of lives of alternatives
Selected alternative will be repeated in succeeding life cycles in
same manner as for the first life cycle
All cash flows will be same in every life cycle (i.e., will change by
only inflation or deflation rate)

©McGraw-Hill Education.

2
 2/15/2023

ACTIVE LEARNING1
AW and Multiple Life Cycles
▪ New digital scanning graphics equipment is
expected to cost $20,000, to be used for 3
years, and to have an annual operating cost
(AOC) of $8000.
▪ Determine the AW values for one and two life cycles
at i = 22% per year.

ACTIVE LEARNING 1
Answers

AW of cycle 1 with i = 22% Estimated costs over

AW = -20,000(A/P,22%,3) - 8000 two life cycles
= $-17,793 per year

AW over 2 cycles
AW = -20,000(A/P,22%,6)
-20,000(P/F,22%,3)(A/P,22%,6)
- 8000
= $-17,793 per year

Demonstrates that AW will be the

same for any number of cycles

3
 2/15/2023

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)

A𝐧𝐝, 𝐀𝐧𝐧𝐮𝐚𝐥 𝐖𝐨𝐫𝐭𝐡: 𝐀𝐖 = 𝐂𝐑 + 𝐀𝐎𝐂

AOC: Annual Operating Cost

CR: AW of Initial Investment + AW of salvage value

©McGraw-Hill Education.

12

ACTIVE LEARNING2
Capital Recovery (CR)
▪ Lockheed Martin is increasing its booster thrust power in
order to win more satellite launch contracts from European
companies interested in new global communications
markets.
▪ A piece of earth-based tracking equipment is expected to
require an investment of $13 million. 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.

13

4
 2/15/2023

ACTIVE LEARNING 2
Answers

▪ Project cost: P = $-13 million

▪ Estimated salvage: S = $0.5 million
▪ Estimated life: n = 8 years
▪ Expected return: i = 12% per year

Calculate the AW value for the system if the

corporate MARR is currently 12% per year.

14

2
ACTIVE LEARNING

Cashflow for Capital Recovery

S = $0.5M
0 1 2 6 7 8

0 1 2 6 7 8

Return expected: Capital recovery:

P = $13M
i = 12% Find A per year

Capital recovery is the equivalent annual amount A to recover $13M at 12%

per year if the salvage is $0.5M after 8 years

CR = -13M(A/P,12%,8) + 0.5M(A/F,12%,8) = $-2.576 per year

Interpretation: Project must develop revenue of at least $2.576M per

year to recover P and make 12% on the investment

Formula: CR = -P(A/P,i,n) + S(A/F,i,n)

15

5
 2/15/2023

ACTIVE LEARNING 2
Example - Cash Flows for AW
S = $0.5M
0 1 2 6 7 8 0 1 2 6 7 8

AOC = $0.9M

AW = $-3.476M per year

P = $13M

This is the AW for all future life cycles of 8 years

each, provided cost estimates change at exactly
the inflation or deflation rate

16

AW-Based Evaluation
Single project analysis Multiple alternatives

▪ Calculate AW of each
▪ Calculate AW at stated alternative at MARR over
MARR over expected respective life or study
period
life
▪ Selection criterion:
Select alternative with most
▪ Acceptance criterion: favorable AW value, that is,
If AW ≥ 0, project is numerically largest AW value
▪ less negative for cost alternatives
economically justified or
▪ more positive for revenue
alternative

22

6
 2/15/2023

ME Alternative Evaluation by AW
Not necessary to use LCM for different life alternatives

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
©McGraw-Hill Education.

23

AW of Long-Life or Infinite-Life Investment

▪ AW of alternative that will last ‘forever’

▪ This is the annual worth equivalent of capitalized cost (CC)
𝐴𝑊
▪ Solve for AW in relation 𝑃𝑊 = from chapter 5
𝑖

AW = PW × i = CC × i

Procedure:
Regular interval cash flows -- find AW over one cycle
Non-regular intervals -- find PW, then calculate AW = PW × i
for long-term AW

30

7
 2/15/2023

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
©McGraw-Hill Education.

31

ACTIVE LEARNING4
AW of Long-Life Investment
▪ How long must $10,000 remain invested at 5%
per year so that $2000 per year can be
withdrawn forever?

n+1

32

8
 2/15/2023

ACTIVE LEARNING 4
Answers

P = A/i determines total in year n to generate $2000 forever

P = 2000/0.05 = $40,000

F/P factor determines n if money grows at 5%, with no

withdrawals
40,000 = 10,000(F/P,5%,n) n = 28.4 years

33

5
ACTIVE LEARNING

AW Comparison of Proposals
Comparison of short-lived and long-lived (forever)
alternatives at i = 5% per year
For each proposal, determine CR and AW values

Prop P and S AOC Life CR and AW

P = $-650,000 CR over 10; add
A S = $17,000
A = $-170,000 10
AOC

A = $-5,000 CR over ∞; add

AOC; add AW of
B P = $-4 million $-30,000 every ‘forever’
periodic repair
5 years over 5 years
CR over 50; add
C P = $-6 million A = $-3,000 50
AOC
cont →

34

9
 2/15/2023

ACTIVE LEARNING 5
Answers

AWA = - 650,000(A/P,5%,10) + 17,000(A/F,5%,10) -

170,000
= $-252,824
AWB = - 4,000,000(0.05) - 5,000 - 30,000(A/F,5%,5)
= $-210,429
AWC = - 6,000,000(A/P,5%,50) - 3,000
= $-331,680

Select proposal B

35

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)

Life-cycle cost analysis includes all costs over a project’s life

span

©McGraw-Hill Education.

38

10