Annual Equivalent Method

OBJECTIVES After studying this chapter, you should

be able to understand:
1. What is Annual Equivalent Amount
2. Numerical / Problems
LEARNING
 Introduction
• In annual equivalent method of comparison, first the annual
equivalent cost or the revenue of each alternative will be
computed.
• Then, the alternative with the maximum annual equivalent
revenue in the case of revenue-based comparison or with the
minimum annual equivalent cost in the case of cost-based
comparison will be selected as the best alternative.
 Annual Equivalent Method
There are two methods in calculating annual equivalent method..
They are
• Revenue dominated cash flow diagram
• Cost dominated cash flow diagram
Revenue dominated cash flow diagram :

Where,
P – Represents initial investment ; Rj – Net revenue at the end
of jth year ; S – Represent the salvage value at the end of nth year
 Annual Equivalent Method
1. The first step is to find the net present worth of the cash flow
diagram using the following expression for a given interest rate, i:
PW(i) = - P + R1 / (1+ i)1 + R2 /(1+i)2 + … + Rj/(1+i)j
+ … + Rn/(1+i)n + S/(1+i)n
In the above formula, the expenditure is assigned with negative
sign and revenues are assigned with positive sign.
2. In the second step, the annual equivalent revenue is computed
using the following formula:

A = PW(i) i(1+i)n = PW(i) (A/P, i , n)

(1+i)n - 1
Where (A/P, i ,n) is called equal payment series capital recovery
factor
 Annual Equivalent Method
Cost dominated cash flow diagram :

Where,
P – Represents initial investment
Cj – Net cost of the operation and maintenance at the end of jth year.
S – Represent the salvage value at the end of nth year
 Annual Equivalent Method
1. The first step is to find the net present worth of the cash flow
diagram using the following expression for a given interest rate, i:
PW(i) = P + C1 / (1+ i)1 + C2 /(1+i)2 + … + Cj/(1+i)j
+ … + Cn/(1+i)n - S/(1+i)n
In the above formula, the expenditure is assigned with positive
sign and salvage value are assigned with negative sign.
2. In the second step, the annual equivalent cost is computed using
the following formula:

A = PW(i) i(1+i)n = PW(i) (A/P, i , n)

(1+i)n - 1
Where (A/P, i ,n) is called equal payment series capital recovery
factor
 Solved Problems
1. A Company is planning to purchase an advanced machine centre.
Three original manufacturers have responded to its tender whose
particulars are tabulated as follows:
Manufacturer Down payment Yearly equal No. of
Rs installment installments
Rs
1 5,00,000 2,00,000 15
2 4,00,000 3,00,000 15
3 6,00,000 1,50,000 15

Determine the best alternative based on the annual equivalent method

by assuming i = 20%, compounded annually.
 Solved Problems
2. A company invests in one of the two mutually exclusive alternatives.
The life of both alternatives is estimated to be 5 years with the
following investments, annual returns and salvage values.

Alternative
A B
Investment (Rs) -1,50,000 - 1,75,000
Annual equal return (Rs) + 60,000 + 70,000
Salvage value (Rs) + 15,000 + 35,000

Determine the best alternative based on the annual equivalent method

by assuming i = 25%.
 Solved Problems
3. Two possible routes for laying a power line are under study. Data on the
routes are as follows:
Around the lake Under the lake
Length 15 km 5 km
First cost (Rs) 1,50,000 / km 7,50,000 / km
Useful life (years) 15 15
Maintenance cost (Rs) 6,000 / km / yr 12,000 / km /yr
Salvage value (Rs) 90,000 / km 1,50,000 / km
Yearly power loss (Rs) 15,000 / km 15,000 / km

If 15% interest is used, should the power line be routed around the lake or
under the lake?
 Solved Problems
4. A suburban taxi company is analyzing the proposal of buying cars with
diesel engines instead of petrol engines. The cars average 60,000 km a
year with a useful life of three years for the petrol taxi and four years
for the diesel taxi. Other comparative details are as follows :
Diesel Petrol
Vehicle Cost (Rs) 3,90,000 3,60,000
Fuel cost per litre (Rs) 8 20
Mileage in km / litre 30 20
Annual repairs (Rs) 9,000 6,000
Annual insurance premium (Rs) 15,000 15,000
Resale value at the end of
60,000 90,000
vehicle life (Rs)

Determine the more economical choice if interest rate is 20%,

compounded annually.
 Solved Problems
1. Soln: Alternative 1
Given data: P= Rs. 5,00,000/- ; A = Rs. 2,00,000/- ; n = 15 yrs
i = 20%
The CFD for the manufacturer 1 is shown below:
1 2 3 4 15
0

i =20 %
A= Rs. 2,00,000 A= Rs. 2,00,000
Rs. 5,00,000

The annual equivalent cost expression is given by,

AE1(20%) = P(A/P, i, n) + A
= 5,00,000 (A/P, 20%,15) + 2,00,000
= 5,00,000(0.2139) + 2,00,000
= Rs 3,06,950/-
 Solved Problems
1. Soln: Alternative 2
Given data: P= Rs. 4,00,000/- ; A = Rs. 3,00,000/- ; n = 15 yrs
i = 20%
The CFD for the alternative A is shown below:
1 2 3 4 15
0

i =20 %
A= Rs. 3,00,000 A= Rs. 3,00,000
Rs. 4,00,000

The annual equivalent cost expression is given by,

AE2(20%) = P(A/P, i, n) + A
= 4,00,000 (A/P, 20%,15) + 3,00,000
= 4,00,000(0.2139) + 3,00,000
= Rs 3,85,560/-
 Solved Problems
1. Soln: Alternative 3
Given data: P= Rs. 6,00,000/- ; A = Rs. 1,50,000/- ; n = 15 yrs
i = 20%
The CFD for the alternative A is shown below:
1 2 3 4 15
0

i =20 %
A= Rs. 1,50,000 A= Rs. 1,50,000
Rs. 6,00,000

The annual equivalent cost expression is given by,

AE3(20%) = P(A/P, i, n) + A = 6,00,000 (A/P, 20%,15) +
1,50,000
= 6,00,000(0.2139) + 1,50,000
= Rs 2,78,340/-
Interpretation: The annual equivalent cost of manufacturer 3 is less
 Solved Problems
2. Soln: Alternative A
Given data: P= Rs. 1,50,000/- ; A = Rs. 60,000/- ; Life = 5 yrs
S = Rs 15,000 ; i = 25% compounded annually
The CFD for the alternative A is shown below:
60,000 60,000 60,000 + 15,000

0 5 t
1 2 3 4
i =25 %

Rs. 1,50,000
The annual equivalent revenue expression is given
by,
AEA (i%) = - P(A/P, i, n) + A + S (A/F, i , n)
= -1,50,000 (A/P, 25%,5) + 60,000 + 15,000
(A/F,25%,5)
 Solved Problems
2. Soln: Alternative B
Given data: P= Rs. 1,75,000/- ; A = Rs. 70,000/- ; Life = 5 yrs
S = Rs 35,000 ; i = 25% compounded annually
The CFD for the alternative A is shown below:
70,000 70,000 70,000 + 35,000

0 5 t
1 2 3 4
i =25 %

Rs. 1,75,000
The annual equivalent revenue expression is given
by,
AEB (i%) = - P(A/P, i, n) + A + S (A/F, i , n)
= -1,75,000 (A/P, 25%,5) + 70,000 + 35,000
(A/F,25%,5)
 Solved Problems
3. Soln: Alternative 1 – Around the lake
Given data: First Cost P= 1,50,000 * 15 = Rs 22,50,000/- ;
Maintenance Cost per year = 6,000 * 15 = Rs 90,000/- ; n = 15 yrs
Power loss per year = 15,000 * 15 = Rs 2,25,000/-
Maintenance cost & power loss/yr A = 90,000+2,25,000/-=Rs
3,15,000/- Salvage value S = 90,000 * 15 = Rs 13,50,000/- ; i = 15%
S= Rs. 13,50,000
The CFD for Alternative 1:
1 2 3 4 15
0
i =15 %

A= Rs. 3,15,000 A= Rs. 3,15,000

P =Rs. 22,50,000
AEA (15%) = P(A/P, i, n) + A - S (A/F, i , n)
= 22,50,000(A/P, 15%,15) + 3,15,000 –
13,50,000(A/F,15%,15)
= 22,50,000(0.1710) + 3,15,000 – 13,50,000(0.0210)
 Solved Problems
3. Soln: Alternative 2 – Under the lake
Given data: First Cost P= 7,50,000 * 5 = Rs 37,50,000/- ;
Maintenance Cost per year = 12,000 * 5 = Rs 60,000/- ; n = 15 yrs
Power loss per year = 15,000 * 5 = Rs 75,000/-
Maintenance cost & power loss/yr A= 60,000+ 75,000/-= Rs. 1,35,000/-
Salvage value S = 1,50,000 * 5 = Rs 7,50,000/- ; i = 15%
S= Rs. 7,50,000
The CFD for Alternative 1:
1 2 3 4 15
0
i =15 %

A= Rs. 1,35,000 A= Rs. 1,35,000

P =Rs. 37,50,000
AEA (15%) = P(A/P, i, n) + A - S (A/F, i , n)
= 37,50,000(A/P, 15%,15) + 1,35,000 –
7,50,000(A/F,15%,15)
= 37,50,000(0.1710) + 3,15,000 – 7,50,000(0.0210)
 Solved Problems
4. Soln: Alternative 1 – Purchase of diesel taxi
Given data: Vehicle Cost P=Rs 3,90,000/- ;
No. of litres /year = 60,000 / 30 = Rs 2,000/- ; Life = 4 yrs
Fuel cost / year = 2,000 * 8 = Rs 16,000/-
Fuel cost, annual repairs & insurance premium/yr = 16,000 + 9,000 +
15,000=Rs 40,000/- ; Salvage value S = Rs 60,000/- ; i = 20%
S= Rs. 60,000
The CFD for Alternative 1:
1 2 3 4
0
i =20 %

P =Rs. 3,90,000 A= Rs. 40,000 A= Rs. 40,000

AE1 (20%) = P(A/P, i, n) + A - S (A/F, i , n)

= 3,90,000(A/P, 20%,4) + 40,000 – 60,000(A/F,20%,4)
= 3,90,000(0.3863) + 40,000 – 60,000(0.1863)
 Solved Problems
4. Soln: Alternative 2 – Purchase of petrol taxi
Given data: Vehicle Cost P=Rs 3,60,000/- ;
No. of litres /year = 60,000 / 20 = Rs 3,000/- ; Life = 3 yrs
Fuel cost / year = 3,000 * 20 = Rs 60,000/-
Fuel cost, annual repairs & insurance premium/yr = 60,000 + 6,000 +
15,000=Rs 81,000/- ; Salvage value S = Rs 90,000/- ; i = 20%
The CFD for Alternative 2: S= Rs. 90,000
1 2 3
0
i =20 %

P =Rs. 3,60,000 A= Rs. 81,000 A= Rs. 81,000

AE2 (20%) = P(A/P, i, n) + A - S (A/F, i , n)

= 3,60,000(A/P, 20%,3) + 81,000 – 90,000(A/F,20%,3)
= 3,60,000(0.4747) + 81,000 – 90,000(0.2747)
 Solved Problems
2. The property appraisal district for Marin County has just installed new

software to track residential market values for property tax computations. The

manager wants to know the total equivalent cost of all future costs incurred when

the three county judges agreed to purchase the software system. If the new

system will be used for indefinite future, find the equivalent value (a) now and

(b) for each year hereafter. The system has an installed cost of $150,000 and an

additional cost of $50,000 after 10 years. The annual software maintenance

contract cost is $5000 for the first 4 years and $8000 thereafter. In addition, there

is expected to be a recurring major upgrade cost of $15,000 every 13 years.

Assume that i = 5% per year for county funds.

 Recap

1. What is Annual equivalent

method
2. Numerical / Problems