ENGR. JOMAR S.

RAMOS ENGINEERING ECONOMY

Advantages and Uses of Annual Worth Analysis
For many engineering economic studies, the AW method is the best to use, when compared to
PW, FW, and rate of return. Since the AW value is the equivalent uniform annual worth of all
estimated receipts and disbursements during the life cycle of the project or alternative, AW is
easy to understand by any individual acquainted with annual amounts, for example, dollars per
year. The AW value, which has the same interpretation as A used thus far, is the economic
equivalent of the PW and FW values at the MARR for n years. All three can be easily determined
from each other by the relation

The n in the factors is the number of years for equal-service comparison. This is the LCM or the
stated study period of the PW or FW analysis.

When all cash flow estimates are converted to an AW value, this value applies for every year of
the life cycle and for each additional life cycle.
Sample Problem

National Homebuilders, Inc., plans to purchase new cut-and-finish equipment. Two

manufacturers offered the estimates below.

A. Determine which vendor should be selected on the basis of a present worth

comparison, if the MARR is 15% per year.
B. National Homebuilders has a standard practice of evaluating all options over a
18-year period. If a study period of 18 years is used and the salvage values are
not expected to change, which vendor should be selected?
Sample Problem

In the previous example, 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). Demonstrate the equivalence at i 15% of PW over three life cycles and AW over one
cycle. In the previous example, present worth for vendor A was calculated as PW $45,036.
CALCULATION OF CAPITAL RECOVERY AND AW VALUES

An alternative should have the following cash flow estimates:

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. Use this amount as P .

Salvage value S. This is the terminal estimated value of assets at the end of their useful
life. The S is zero if no salvage is anticipated; S is negative when it will cost money to
dispose of the assets. 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.

Annual amount A. This is the equivalent annual amount (costs only for cost
alternatives; costs and receipts for revenue alternatives). Often this is the annual
operating cost (AOC) or M&O cost, so the estimate is already an equivalent A value.
CALCULATION OF CAPITAL RECOVERY AND AW VALUES

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,

Both CR and A represent costs. The total annual amount A is determined from uniform
recurring costs (and possibly receipts) and nonrecurring amounts. The PA and PF
factors may be necessary to first obtain a present worth amount; then the AP factor
converts this amount to the A value. (If the alternative is a revenue project, there will be
positive cash flow estimates present in the calculation of the A value.)
CALCULATION OF CAPITAL RECOVERY AND AW VALUES

The recovery of an amount of capital P committed to an asset, plus the time value of the
capital at a particular interest rate, is a fundamental principle of economic analysis.

The AP 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 assets useful life, its equivalent
annual value is recovered using the AF factor. This action reduces the equivalent annual
cost of the asset. Accordingly, CR is calculated as
Sample Problem

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.
EVALUATING ALTERNATIVES BY ANNUAL WORTH ANALYSIS

The annual worth method is typically the easiest to apply of the evaluation techniques
when the MARR is specified. The AW is calculated over the respective life of each
alternative, and the selection guidelines are the same as those used for the PW method.
For mutually exclusive alternatives, whether cost- or revenue-based, the guidelines are
as follows:
Sample Problem

Yellow Cab 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%. Perform an annual worth evaluation for the owner that answers the following questions.

A. How much new annual net income is necessary to recover the investment at the MARR of 10% per
year?
B. Jerry estimates increased net income of $6000 per year for all five systems. Is this project
financially viable at the MARR?
C. Based on the answer in part ( b ), determine how much new net income Yellow Cab Pizza must
have to economically justify the project. Operating costs remain as estimated.
Sample Problem

A quarry outside of Austin, Texas wishes to evaluate two similar pieces of equipment by
which the company can meet new state environmental requirements for dust emissions.
The MARR is 12% per year. Determine which alternative is economically better using (a)
the AW method, and (b) AW method with a 3-year study period.