Annual Worth Analysis
Introduction
Annual Worth is also known by other titles
• Equivalent Annual Worth (EAW)
• Equivalent Annual Cost (EAC)
• Annual Equivalent (AE)
• Equivalent Uniform Annual Benefit (EUAB)
• Equivalent Uniform Annual Cost (EUAC)
Properties of AW
• The alternative selected by the AW method
will always be the same as that selected by
the PW method, and all other alternative
evaluation methods.
• An additional application of AW analysis
treated here is life-cycle cost (LCC) analysis.
• This method considers all costs of a product,
process, or system from concept to phase-out.
Advantages
• The annual worth method offers a prime
computational and interpretation advantage
because the AW value needs to be calculated
for only one life cycle.
• The AW value determined over one life cycle
is the AW for all future life cycles. Therefore,
it is not necessary to use the LCM of lives to
satisfy the equal-service requirement.
Calculate the equivalent uniform annual
worth for both vendors at 15% MARR
Solution
• Calculate the equivalent uniform annual worth
value for all cash flows in the first life cycle.
• AW = — 15,000(A/P, 15%,6) +1000(A/F,15%,6)
- 3500 = $-7349
• When the same computation is performed on
each succeeding life cycle, the AW value is $-
7349.
PW (Earlier Example)
Contd..
• AW = -45,036(A/P, 15 %, 18) = $-7349
• The one-life-cycle AW value and the AW value
based on 18 years are equal.
Calculation of Capital Recovery and AW
Values
• Initial investment P. This is the total first cost of
all assets and services required to initiate the
alternative. When portions of these investments
take place over several years, their present
worth is an equivalent initial investment.
• Salvage value S. This is the terminal estimated
value of assets at the end of their useful life. S is
zero if no salvage is anticipated; S is negative
when it will cost money to dispose of the assets.
• Annual amount A. This is the equivalent
annual amount (costs only for cost
alternatives; costs and receipts for revenue
alternatives).
• The annual worth (AW) value for an
alternative is comprised of two components:
capital recovery for the initial investment P at
a stated interest rate (usually the MARR) and
the equivalent annual amount A.
• The symbol CR is used for the capital recovery
component. In equation form:
• AW = CR + A
• Capital recovery (CR) is the equivalent annual
amount that the asset, process, or system
must earn (new revenue) each year to just
recover the initial investment plus a stated
rate of return over its expected life.
• Any expected salvage value is considered in
the computation of CR.
• The A/P factor is used to convert P to an equivalent
annual cost.
• If there is some anticipated positive salvage value S
at the end of the asset’s useful life, its equivalent
annual value is recovered using the A/F factor.
• This action reduces the equivalent annual cost of
the asset. Accordingly, CR is calculated as:
• CR = -P(A/P,i,n) + S(A/F,i,n)
Example
• 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 are expected to start in
the first year and continue at $0.9 million per
year. The useful life of the machine 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.
Solution
• Capital recovery: Determine P in year 0 of the
two initial investment amounts, followed by
calculate the capital recovery.
• 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
Interpretation
• It means that each and every year for 8 years,
the equivalent total net revenue from the
machine 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.
Contd..
• Annual worth: To determine AW, the cash
flows must be converted to an equivalent AW
series over 8 years
• Since CR = $-2.47 million is an equivalent
annual cost, as indicated by the minus sign,
total AW is determined as follows:
• AW = -2.47 -0.9 = $ -3.37 million per year
Alternative Method
• There is a second, equally correct way to
determine CR. Either method results in the
same value.
• There is a relation between the A/P and A/F
factors.
• (A/F,i,n) = (A/P,i,n) - i
• Both factors are present in the CR Equation.
Substitute for the A/F factor to obtain CR
• CR = -P(A/P,i,n) + S[(A/P,i,n) - i]
• = - [(P - S)(A/P,i,n) + S(i)]
• Subtracting S from the initial investment P
before applying the A/P factor recognizes that
the salvage value will be recovered. This
reduces CR, the annual cost of asset
ownership.
• Why add S(i)?
Repeat in alternate method
• 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 are expected to start
the first year and continue at $0.9 million per
year. The useful life of the machine 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.
Evaluating Alternatives by Annual Worth
• One alternative: If AW > 0, the requested
MARR is met or exceeded and the alternative
is economically justified.
• Two or more alternatives: Select the
alternative with the AW that is numerically
largest, that is, less negative or more positive.
• This indicates a lower AW of cost for cost
alternatives or a larger AW of net cash flows
for revenue alternatives.
Example
• A machine costs $4600, has a 5-year useful life,
and may be salvaged for an estimated $300. Total
operating cost for the machine is $200 for the
first year, increasing by $100 per year thereafter.
$1200 is the annual income. The MARR is 10%.
• Answer following questions:
1. How much new annual net income is
necessary to recover the investment at the
MARR of 10% per year? (Capital Recovery)
2. Owner estimates increased net income of
$1200 per year. Is this project financially
viable at the MARR?
3. Based on the answer in part (b), determine
how much new net income company must
have to economically justify the project.
Operating costs remain as estimated.
Solution
• (a) The capital recovery amount:
• CR = -4600(A/P, 10%,5) + 300(A/F, 10%,5)
• = -4600(0.26380) + 300(0.16380)
• = $-1164.4
• The machine must generate an equivalent
annual new revenue of $1164.4 to recover the
initial investment plus a 10% per year return.
• b) The annual operating cost series, combined
with the estimated $1200 annual income,
forms an arithmetic gradient series with a
base amount of $1200 and G = $-100. The
project is financially viable if AW > 0 at i = 10%
per year.
• AW = CR + A
• = -1164.4 + 1200 –200- 100(A/G,10%,5)
• =$-345
• The system is not financially justified at the
net income level of $1200 per year.
• (c) Let the required income equal R, and set
the AW relation equal to zero to find the
minimum income to justify the system.
• 0 = -1164.4 + (R - 200) - 100(A/G,10%,5)
• R = -1164.4 - 200 - 100(1.8101)
• = $ 1545per year
AW of a Permanent Investment
• Evaluation of public sector projects, such as
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 (and
capital recovery amount) of the initial investment
is the perpetual annual interest on the initial
investment, that is, A = Pi = (CC)i.
Example
A B C
First Cost 650000 4 Million 6 million
O&M Cost 50000 5000 3000
Other Costs 120000 30000 for every 5
years
Salvage Value 17000
Life 10 Permanent 50 years
Solution
• Since this is an investment for a permanent
project, compute the AW for one cycle of all
recurring costs.
• Proposal A
• First Cost= -650,000 (A/P,5%, 10) +
17,000(A/F,5%,10)= $ -82,824
• O&M= -50,000
• Other Cost= -120,000
• $-252,824
• Proposal B
• First Cost= -4,000,000(0.05) = $ 200,000
• O&M cost -5,000
• Other Cost: — 30,000(A/F,5%,5) = -5,429
• $-210,429
• Proposal C
• First Cost: -6,000,000(A/P,5%,50) = $-328,680
• O&M cost -3,000
• $-331,680
Example
• Assume that your parents wanted to make investment for
your education from the first birthday onwards for 20 years
in equal amounts so that they can finance 4 years
engineering education. Annual fee is Rs. 1 Lakh, hostel fee is
Rs. 50000 per annum and is expected to increase by Rs.
5000 from the second year onwards and other expense is Rs.
50000 per annum and is expected to increase by 15% per
annum. At 10% interest how much money should be saved
for 20 years?
Solution
• Present value of the GG is 50000
{1-[(1.15)/(1.1)]^4}/(0.1-0.15)
• = -194594.8 at 17th year
• -150000 (P/A, 10%, 4) -5000 (P/G, 10%, 4) - -
194594.8
• -150000 (3.170) -5000 (4.378) -194594.8
• = -475500 -21890 -194594.8
• = -691984.8 at 17th year
Solution
• Take it to the end of the 20th year
• = -691984.8 (F/P, 10%, 3)
• = -691984.8 (1.331)
• = -921032.8
• AW for 20 years
• = -921032.8 (A/F, 10%, 20)
• = -921032.8 (.0175)
• AW for 20 years = -16118.1
Typical Life-Cycle Cost Distribution by Phase
Life-Cycle Cost Analysis
LCC analysis includes all costs for entire life span,
from concept to disposal
Best when large percentage of costs are M&O
Includes phases of acquisition, operation, & phaseout
Apply the AW method for LCC analysis of 1 or more cost alternatives
Use PW analysis if there are revenues and other benefits considered
Application of PW/AW
• STRIPS
• Mortgage Backed Securities
