Engineering Economy

Chapter 5
Fall 2018

Dr. Ako Rashed Hama

 Engineering Economy
Chap 5: Annual Worth Analysis

Formulating Alternatives based on Annual Worth

P, A, F (S) AW = ?
AW also known as:
Annual Equivalent (AE), Equivalent Annual Cost (EAC),
Equivalent Uniform Annual Cost (or Worth), EUAC (or EUAW)
Advantage
Annual Worth is calculated for only one life cycle
10/30/2018
but would be same for future cycles! 2
 Engineering Economy
Chap 5: Annual Worth Analysis

Example 1
Demonstrate that AW will be the same for any number of life cycle:
1st cost = $25,000, i = 22% / year, A cost = $8,000, salvage = $1000, n = 3
AW over one cycle:
AW = -25,000(A/P,22%,3)-8000+1000(A/F,22%,3)= $3,972 per year

AW of one and two life cycles

AW over 2 cycles:
$1000 $1000 AW = -25,000(A/P,22%,6)
0 1 2 3 4 5 6 -24,000(P/F,22%,3)(A/P,22%,6)
$8000 / year $8000 / year
-8000
+1000(A/F,22%,6)
$25000 $25000 = $3,972 per year
10/30/2018 3
 Engineering Economy
Chap 5: Annual Worth Analysis

? ?
PW = FW = AW
AW = PW(A/P,i%,n) = FW(A/F,i%,n) [5.1]
where n = LCM (equal service) or length of study period:

1. Capital Recovery (CR):

the equivalent annual amount A that a project must earn each year
to recover the first cost plus the stated ROR over its expected life
Salvage value be considered for calculating CR:
CR = -P(A/P,i%,n) + S(A/F,i%,n) [5.2]

AW = Capital recovery (CR) + Equivalent annual A of op. costs (A of AOC)

AW = CR + A [5.3]
10/30/2018 4
 Engineering Economy
Chap 5: Annual Worth Analysis

Example 2
Determine the AW of Example 1 on the basis of capital recovery CR.
1st cost = $25,000, i = 22% / year, A cost = $8,000, salvage = $1000, n = 3
From Eq. [5.2] and [5.3]:
CR = -25000(A/P,22%,3) + 1000(A/F,22%,3) = $11,972 per year
AW = CR + A = $3,972 per year

Example 3
A project has the following finance data:
present costs P = $-13 M, Salvage S = $0.5 M, Life = 8, i = 12% / year
a) Define and calculate the Capital Recovery.
b) If the annual op. cost AOC = $0.9 M, estimate the AW of the project.
10/30/2018 5
 Engineering Economy
Chap 5: Annual Worth Analysis

Example 3.a
S = $0.5M

0 1 2 6 7 8 0 1 2 6 7 8

Return expected i = 12% Capital Recovery A per year = ?

P = $13M

CR= equivalent annual amount A to recover $13M at 12% per year if the
salvage is $0.5M after 8 years
From [5.2]: CR = -13M(A/P,12%,8) + 0.5M(A/F,12%,8) = $-2,576M per year

Conclusion: Project must develop revenue of at least $2,576M per year to

recover P and make 12% on the investment
10/30/2018 6
 Engineering Economy
Chap 5: Annual Worth Analysis

Example 3.b
S = $0.5M

0 1 2 6 7 8 0 1 2 6 7 8

Annual Op Cost = $0.9M Annual Worth per year = ?

P = $13M

From Eq. [5.3] and considering AOC = $0.9M / year:

AW = -2.576M per year – 0.9M per year = $-3.476M per year
AW for all future life cycles of 8 years each
Conclusion: Project must develop revenue of at least $3.476M per year to
recover P, A and return 12% per year
10/30/2018 7
 Engineering Economy
Chap 5: Annual Worth Analysis
2. Evaluating Alternatives by AW Analysis:
 for single project, if AW ≥ 0, it is economically justified
 for ME projects, after inferring the AW of each alternative
select one with numerically largest AW
Example 4

10/30/2018 8
 Engineering Economy
Chap 5: Annual Worth Analysis

Example 4
a) AWX = -40,000(A/P,12%,4) + 10,000(A/F,12%,4) – 25,000 = $-36,077
AWY = -75,000(A/P,12%,6) + 7,000(A/F,12%,6) – 15,000 = $-32,380
Equipment Y is selected
b) AWX = -40,000(A/P,12%,3) + 14,000(A/F,12%,3) – 25,000 = $-37,505
AWY = -75,000(A/P,12%,3) + 20,000(A/F,12%,3) – 15,000 = $-40,299
Equipment X would be selected
Example 5
In the Example 4, if the selected equipment will be retained for a total of
8 years. Additionally, assume after 8 years S = 0 for X and Y; and AOCX
continues at $25,000, but AOCY doubles starting in year 7. What
equipment on a basis of 8 year study period should be selected?
10/30/2018 9
 Engineering Economy
Chap 5: Annual Worth Analysis

Example 5
0 1 2 6 7 8 0 1 2 6 7 8

AOC = $25,000 AOC = $15,000

AOC = $30,000
P = $40,000

Equipment X P = $75,000 Equipment Y

Study period is n = 8 years:

AWX = -40,000(A/P,12%,8) – 25,000 = $-33,052
AWY = -75,000(A/P,12%,8) – 15,000 - 15,000(F/A,12%,2)(A/F,12%,8)
= $-32,683
still select Y as the greater AW (or cheaper choice)
10/30/2018 10
 Engineering Economy
Chap 5: Annual Worth Analysis

3. AW of Permanent Investment:
AW of alternative that will last forever
Annual Worth equivalent of Capitalized Cost (CC)
from Chapter 4 for n→∞: PW = AW / i
AW = PW x i = CC x i [5.4]
Example 6

Pn ≡ how much has to be accumulated at the time that the $2000 annual withdrawals start
10/30/2018 11
 Engineering Economy
Chap 5: Annual Worth Analysis

Example 6
First finding Pn: P = A / i = 2000 / 0.08 = $25,000
Then F/P factor determines n if money grows at 8%, with no withdrawals:
25,000 = 10,000(F/P,8%,n) = 10,000 (1+i)n => (1+0.08)n = 2.5
ln (1.08)n= ln 2.5 => n (ln 1.08) = ln 2.5 => n = 11.91 years
Example 7
Determine the CR and AW of each system below, then selected the best.
system P and S AOC Life i CR and AW

P = $650,000
A A = $170,000 10 5% CR over 10; add AOC
S = $17,000
A = $5,000 CR over∞; add AOC;
B P = $4 M forever 5%
$30,000 every 5 years add periodic repair over 5 years
C P = $6 M A = $3,000 50 5% CR over 50; add AOC

10/30/2018 12
 Engineering Economy
Chap 5: Annual Worth Analysis

Example 7
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 Select B
AWC = - 6,000,000(A/P,5%,50) - 3,000 = $-331,680

4. Spreadsheet Evaluation Using AW Analysis:

sum of CR and A of AOC, if AOC is uniform
AW function = PMT(i%,n,P,-S) – A
Note signs on P, S and A to obtain correct sign on result!
If AOC is not uniform, enter annual estimates, find their P value, then use
PMT.
Or, use embedded NPV function
= PMT(i%,n, P+NPV(i%,year_1_cell,year_n_cell))
10/30/2018 13
 Engineering Economy
Chap 5: Annual Worth Analysis

Example 8
Spreadsheet-based AW analysis in Example 7 – 3 alternatives with
different lives

AWA; n = 10: PMT(5%,10,650000,-17000) - 170,000 = $-252,826

AWB; n = ∞: -4,000,000*0.05 - 5,000 + PMT(5%,5,,30000) = $-210,429
AWC; n = 50: PMT(5%,50,6000000) - 3,000 = $-331,660
10/30/2018 14