Annual worth analysis

Introduction

I Annual worth (AW) analysis is a variant of the present

worth analysis discussed in Chapter 5.
I However, AW analysis has many advantages that make it a
useful technique for comparing alternatives.
Advantages of AW analysis

I It’s a popular analysis technique.

I It’s easy to understand. Results are reported in $/year.
I It simplifies the process of comparing alternatives.
I No need to compare two alternatives for LCM years.
I Compare for one life cycle of each alternative only, since A
is the same in the 2nd life cycle, 3rd life cycle, etc. as the
cash flows are repeated in each cycle.
Example

I National Homebuilders, Inc. evaluated cut-and-finish

equipment from vendor A (6-year life) and vendor B
(9-year life). The PW analysis used the LCM of 18 years.
Consider only the vendor A option now. The diagram
below shows the cash flows for all three life cycles (first cost
$15,000; annual M&O costs $3500; salvage value $1000).
I Demonstrate the equivalence at i = 15% of PW over three
life cycles and AW over one cycle. Present worth for vendor
A was calculated as PW = $45,036.
Example
Example

I AW1st cycle =
−15,000(A/P, 15%, 6) + 1000(A/F, 15%, 6) − 3500
I AW1st cycle = $ − 7349 (= AW2nd cycle = AW3rd cycle = ...)
I Check:
I AW1−18 = $ − 45,036 (A/P, 15%, 18) = $ − 7349
| {z }
PW based on 18 years
I The one-life-cycle AW value and the AW value based on 18
years are equal.
How does AW analysis work?

I For alternative j, find the uniform annual series, with value

AWj , which is equivalent to all the cash flows of the
alternative at the decision maker’s MARR.
I An alternative j with AWj ≥ 0 is economically viable.
I Compare annualized series (the AWj ’s) of all alternatives.
I The alternative with largest AWj is selected.
Keep in mind

I P W and AW analysis are equivalent.

I An alternative has AW ≥ 0 if and only if P W ≥ 0.
I An alternative has largest AW among a set of alternatives
if and only if it has the largest P W .
I Note: P W is conducted over LCM.
AW analysis assumptions

I Same as those of PW analysis with the LCM method:

I The service provided by the alternatives will be needed for
LCM years or more.
I An alternative is repeated over each life cycle of the LCM
in exactly the same manner.
I Cash flow estimates are the same in every life cycle.
Capital recovery (CR) calculation

I Capital recovery (CR) is the annualized equivalent of the

initial investment P and the future salvage value S of an
alternative,
I CR = −P (A/P, i, n) + S(A/F, i, n)
I Commonly, CR is added to the equivalent annual amount
(of everything else apart P and S) to get AW ,
I AW = CR + A
I The total annual amount A is determined from uniform
recurring costs (and possibly receipts) and nonrecurring
amounts.
Capital recovery (CR) calculation
I Initial investment P is the total first cost to initiate the
alternative.
I When portions of these investments take place over
several years, their present worth is an equivalent
initial investment. Use this amount as P when
computing CR.
I Salvage value S is the terminal estimated value of assets at
the end of their useful life.
I S is zero if no salvage is anticipated; S is negative when it
will cost money to dispose of the assets.
I For study periods shorter than the useful life, S is the
estimated market value or trade-in value at the end of the
study period.
I AOC = annual operating cost; same as M&O =
maintenance and operating cost
Example

I Lockheed Martin is increasing its booster thrust power in

order to win more satellite launch contracts from European
companies interested in opening up new global
communications markets. A piece of earth-based tracking
equipment is expected to require 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 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 CR and AW values for the
system, if the corporate MARR is 12% per year.
Example

I CR = ?, AW = ?
I First find P for the two parts of the initial investment:
I P = 8 + 5(P/F, 12%, 1) = $12.46 (in millions)
I CR = −12.46(A/P, 12%, 8) + 0.5(A/F, 12%, 8)
I CR = −12.46(0.2013) + 0.5(0.0813) = $ − 2.47 (million)
I Each year for 8 years, we need at least $2,470,000 just to
recover the initial investment at a return of 12% per year.
Example

I AW = CR + A
I AW = −2.47 − 0.9 = $ − 3.37 (million) per year.
Example

I Heavenly Pizza, which is located in Toronto, fares very well

with its competition in offering fast delivery. Many
students at the area universities and community colleges
work part-time delivering orders made via the web. The
owner, Jerry, a software engineering graduate, plans to
purchase and install five portable, in-car systems to
increase delivery speed and accuracy. The systems provide
a link between the web order-placement software and the
On-Star system for satellite-generated directions to any
address in the area. The expected result is faster, friendlier
service to customers and larger income. Each system costs
$4600, has a 5-year useful life, and may be salvaged for an
estimated $300. Total operating cost for all systems is
$1000 for the first year, increasing by $100 per year
thereafter. The MARR is 10%.
Example

I Perform an annual worth evaluation for the owner that

answers the following questions.
I (a) How much new annual net income is necessary to
recover the investment at the MARR of 10% per year?
Example

I Note: there are 5 systems.

I CR = −5 × 4600(A/P, 10%, 5) + 5 × 300(A/F, 10%, 5)
I CR = −23000(0.2638) + 1500(0.1638) = $ − 5822
I The five systems must generate an equivalent annual
revenue of $5822 to recover the initial investment plus a
10% per year return.

I (b) Jerry estimates increased net income of $6000 per year

for all five systems. Is this project financially viable at the
MARR?
Example
I The joint cash flow for all 5 systems is shown below.
I G = 100; viable ?, i.e. AW ≥ 0?
I AW = CR + A
I A = +6000 − 1000 − 100(A/G, 10%, 5)
I AW = −5822 + 5000 − 100(A/G, 10%, 5) = $ − 1003
I AW < 0 =⇒ not viable.
Example

I (c) Based on the answer in part (b), determine how much

new net income Heavenly Pizza must have to economically
justify the project. Operating costs remain as estimated.
Example

I Instead of $6000, assume R:

I AW = −5822 + R − 1000 − 100(A/G, 10%, 5) ≡ 0
I R = 5822 + 1000 + 100(A/G, 10%, 5)
I R = 6822 + 100(1.8101) = $7003 per year
Example
I Luby’s Cafeterias is in the process of forming a separate
business unit that provides meals to facilities for the
elderly, such as assisted care and long-term care centers.
Since the meals are prepared in one central location and
distributed by trucks throughout the city, the equipment
that keeps food and drink cold and hot is very important.
Michele is the general manager of this unit, and she wishes
to choose between two manufacturers of temperature
retention units that are mobile and easy to sterilize after
each use. Use the cost estimates below to select the more
economic unit at a MARR of 8% per year.
Example

I AWH =
−15,000(A/P, 8%, 4) − 6000 + 0.2(15,000)(A/F, 8%, 4)
I AWH = −15,000(0.30192)−6000+3000(0.22192) = $−9863
I For IC unit, assume refurbishment cost includes year 12.
I AWIC = −20,000(A/P, 8%, 12) − 9000 −
2000(A/F, 8%, 4) + 0.4(20,000)(A/F, 8%, 12)
I AWIC = $ − 11,676
Example

I Alternatively (textbook):
I AWIC = −20,000(A/P, 8%, 12) − 9000 −
2000[(P/F, 8%, 4) + (P/F, 8%, 8) +
(P/F, 8%, 12)](A/P, 8%, 12) + 0.4(20, 000)(A/F, 8%, 12)
I AWIC = $ − 11,676
I The Hamilton unit is considerably less costly on an annual
equivalent basis.
Annual worth of permanent investments (n = ∞)

I This is similar to the capitalized cost analysis in Chapter 5.

I For a recurrent cash flow R,
I AR = R(A/F, i, nR )
 
i
I AR = R
(1 + i)nR − 1
I For a non-recurrent cash flow C, occurring at time nC ,
I AC = P WC × (A/P, i, ∞)
I AC = P WC × i
Ci
I AC = C(P/F, i, nc ) × i =
(1 + i)nC
Example

I At the end of each year, all owners and employees at Bell

County Utility Cooperative are given a bonus check based
on the net profit of the Coop for the previous year. Bart
just received his bonus in the amount of $8530. He plans to
invest it in an annuity program that returns 7% per year.
Bart’s long-term plans are to quit the Coop job some years
in the future when he is still young enough to start his own
business. Part of his future living expenses will be paid
from the proceeds that this year’s bonus accumulates over
his remaining years at the Coop.
I (a) Determine the amount of annual year-end withdrawal
that he can anticipate (starting 1 year after he quits) that
will continue forever. He is thinking of working 15 more
years. (b) Determine the amount Bart must accumulate
after 15 years to generate $3000 per year forever.
Example

I (a) F15 = 8530(F/P, 7%, 15) = 8530(1 + 0.07)15 = $23,535

I A = 23,535 (A/P, 7%, ∞) = $1647 per year
| {z }
=i=0.07
I (b) A = $3000 =⇒ F15 = ?
1
I F15 = 3000(P/A, 7%, ∞) = 3000 = $42,857
0.07