Chapter 6:

Annual equivalent-worth analysis

6.1 - Annual equivalent-worth criterion
6.2 - Capital cost versus operating cost
6.3 - Applying annual-worth analysis

(subsections 6.4 and 6.5 will NOT be covered)

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 6.1 - Annual equivalent-worth criterion

The AE criterion provides a basis for measuring the worth

of an investment by determining equal payments on an
annual basis.

Single project evaluation

Comparing multiple alternatives
If we compare cost AND revenues (revenue projects)
If we ONLY compare costs - they all have the same
revenues (service projects)

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 Example 6.1
Figure 6.1 Cash flow diagram (Example 6.1).

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6.1.2 - Annual-worth calculation with repeating cash flow
cycles

In this case we just compute the AE by examining the first

cash flow cycle.

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 Example 6.2

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Figure 6.2 Conversion of repeating cash flow cycles into an equivalent annual payment (Example 6.2).
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6.1.3 - Comparing mutually exclusive alternatives

We need equal time spans.

We consider 2 situations:

1. The analysis period equals project lives we calculate:

a)AE for each REVENUE project and select the project with largest AE
b)AEC for each SERVICE project and select the project with the least
AEC.

2. The analysis period differs from project lives.

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6.1.3 - Comparing mutually exclusive alternatives

The analysis period differs from project lives:

If we have a indefinite service period and replacement with identical

projects we just use the AE analysis, provided that:

1. The service of the selected alternative is required on a continuous

basis
2. Each alternative will be replaced by an identical asset that has the
same costs and performance.

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Figure 6.3 Comparison of projects with unequal lives and an indefinite analysis period using the annual equivalent-worth criterion (Example 6.3).

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6.2 - Capital cost versus operating cost

When only costs are involved, the AE method is called the

AEC method.

In this case, revenues must cover 2 kinds of costs:

1. Operating costs: incurred through the operation of physical

plant or equipment needed to provide service (ex: labor and
raw material)
2. Capital cost: incurred by purchasing assets to be used in
production and service. Normally they are not recurring costs
(i.e. are one-time costs).

The annual equivalent of a capital cost is given the name: capital

recovery cost: CR(i)
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Figure 6.4 Capital recovery (ownership) cost calculation.

CR(i) = I(A/P,i,N) S(A/F,i,N)

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 Example 6.4

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Figure 6.5 Separating ownership cost (capital cost) and operating cost from operating revenue, which must exceed the annual
equivalent cost to make the project acceptable.

Jjjj,

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Figure 6.5 Separating ownership cost (capital cost) and operating cost from operating revenue, which must exceed the annual
equivalent cost to make the project acceptable.

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Problem 6.2
Consider the accompanying cash flow diagram. Compute the
equivalent annual worth at i=10%.

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Problem 6.14
What is the annual equivalent cost of purchasing a lift truck
that has an initial cost of $70.000, an annual operating cost of
$14.000, and an estimated salvage value of $25.000 after six
years of use at an annual interest rate of 6%?

Problem 6.15
You are considering purchasing a dump truck. The truck will
cost $55.000 and have an operating and maintenance cost
that starts at $18.000 the first year and increases by $2.000
per year. Assume that the salvage value at the end of five
years is $12.000 and the interest rate is 12%. What is the
equivalent annual cost of owning and operating the truck?
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Problem 6.40
Consider the cash flows in Table P6.40 for the following investment
projects (MARR=15%).

a) Suppose that projects A and B are mutually exclusive. Which

project would you select, based on the AE criterion?
b) Assume that projects B and C are mutually exclusive. Which
project would you select, based on the AE criterion?

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6.3 Applying annual-worth analysis

Benefits:
1. Consistency of report formats: financial managers commonly
work with annual costs in any number of internal and external
reports.
2. Need for unit costs or profits.
3. Life-cycle cost analysis.

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6.3 Applying annual-worth analysis

1. Unit profit/cost calculation

2. Make-or-buy decision outsourcing decisions
3. Pricing the use of an asset

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1 - Unit profit/cost calculation

In many situations, we need to know the unit profit (or cost)

of operating an asset.
Steps:
1. Determine number of units per year
2. Identify cash flow series
3. Calculate equivalent annual worth
4. Calculate unit profit/cost

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 If number of units per year are the same

AE
Unit profit/cost =
number of units per year

If number of units per year are different we need to

convert them into equivalent annual units

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 Example 6.5

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 Example 6.6

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2 Make-or-buy decision outsourcing decisions

If either the make or buy alternative requires the

acquisition of machinery or equipment, then it becomes an
investment decision.

Since the cost of an outside service (the buy alternative)

is usually quoted in terms of dollars per unit we want to
have the make alternative also given in dollars per unit.

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 Steps:
1. Determine planning horizon
2. Determine annual quantity of product
3. Obtain unit cost of buying the product
4. Determine all the resources required to make the product
5. Estimate cash flows for the make option
6. Compute AEC of producing the product
7. Compute unit cost of producing the product
8. Choose option with minimum unit cost

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 Example 6.7

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Figure 6.6 Make-or-buy analysis.

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3 - Pricing the use of an asset

Companies often need to calculate the cost of equipment

that corresponds to a unit of use of that equipment.
Example: an employers reimbursement of costs for the
use of an employees personal car for business purposes.

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 Example 6.8

annual

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Problem 6.45
A chemical company is considering two types of incinerators to burn
solid waste generated by a chemical operation. Both incinerators have
a burning capacity of 20 tons per day. The data in table P6.45 have
been compiled for comparison.

If the firms MARR is known to be 13%, determine the processing cost

per ton of solid waste incurred by each incinerator. Assume that
incinerator B will be available in the future at the same cost.
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Problem 6.46

Company X has been contracting its overhauling work to

Company Y for $40.000 per machine per year. Company X
estimates that by building a $500.000 maintenance facility
with a life of 15 years and a salvage value of $100.000 at the
end of its life, it could handle its own overhauling at a cost of
only $30.000 per machine per year. What is the minimum
annual number of machines that Company X must operate to
make it economically feasible to build its own facility?
(Assume an interest rate of 12%.)

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