Chapter 6

Annual Worth Analysis

• AW Value and Capital Recovery Calculations

• The annual worth (AW) method is commonly used for comparing alternatives. All cash flows are
converted to an equivalent uniform annual amount over one life cycle of the alternative. The AW
value is easily understood by all since it is stated in terms of dollars per year. The major advantage
over all other methods is that the equal service requirement is met without using the least common
multiple (LCM) of alternative lives.

• The AW value is calculated over one life cycle and is assumed to be exactly the same for any
succeeding cycles, provided all cash flows change with the rate of inflation or deflation. If this
cannot be reasonably assumed, a study period and specific cash flow estimates are needed for the
analysis.
• EXAMPLE

• New digital scanning graphics equipment is expected to cost $20,000, to be used for 3 years, and to
have an annual operating cost (AOC) of $8000. Determine the AW values for one and two life
cycles at i = 22% per year.

• First use the cash flows for one life cycle to determine AW.

AW = −20,000(A/P,22%,3) − 8000 = $−17,793

For two life cycles, calculate AW over 6 years. Note that the
purchase for the second cycle occurs at the end of year 3,
which is year zero for the second life cycle

AW = −20,000(A/P,22%,6) − 20,000(P/F, 22%, 3)

(A/P,22%,6) − 8000
= $−17,793
• The same AW value can be obtained for any number of life cycles, thus demonstrating that the AW value
for one cycle represents the equivalent annual worth of the alternative for every cycle. It is always
possible to determine the AW, PW, and FW values from each other using the following relation.

AW = PW(A/P,i,n) = FW(A/F,i,n)

• The AW value of an alternative is the addition of two distinct components: capital recovery (CR) of the
initial investment and the equivalent A value of the AOC.
AW= CR+A of AOC

• Capital recovery is the equivalent annual cost of owning the asset plus the return on the initial
investment. 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 removed using
the A/F factor. This action reduces the equivalent annual cost of owning the asset. Accordingly, CR is:

CR = −P(A/P,i,n)+S(A/F,i,n)
• The annual amount (A of AOC) is determined from uniform recurring costs (and possibly receipts)
and nonrecurring amounts. The P/A and P/F factors may be necessary to first obtain a present
worth amount, then the A/P factor converts this amount to the A value.

• EXAMPLE

• Lockheed Martin is increasing its booster thrust power in order to win more satellite launch
contracts from European companies interested in new global communications markets. A piece of
earth-based tracking equipment is expected to require an investment of $13 million. 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 AW
value for the system if the corporate MARR is currently 12% per year.
The correct interpretation of this result is very important to Lockheed Martin. It means that each and every
year for 8 years, the equivalent total revenue from the tracker must be at least $2,576,000 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. Total AW is found by:

AW = −2.576 − 0.9 = $−3.476 million per year

• Evaluating Alternatives Based on Annual Worth

• The annual worth method is typically the easiest of the evaluation techniques to perform, when the
MARR is specified. The alternative selected has the lowest equivalent annual cost (cost
alternatives), or highest equivalent income (revenue alternatives). The selection guidelines for the
AW method are the same as for the PW method.

• One alternative: AW ≥ 0, the alternative is financially viable.

• Two or more alternatives: Choose the numerically largest AW value (lowest cost or highest
income).

• If a study period is used to compare two or more alternatives, the AW values are calculated using
cash flow estimates over only the study period. For a study period shorter than the alternative’s
expected life, use an estimated market value for the salvage value.
• EXAMPLE

• PizzaRush, which is located in the general Los Angeles area, 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 at [Link]. The owner, a software engineering
graduate of USC, 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 softwareand the
in-car GPS system for satellite-generated directions to any address in the Los Angeles area. The
expected result is faster, friendlier service to customers, and more income for PizzaRush. 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 $650 for the first year, increasing by $50 per year thereafter. The
MARR is 10% per year.

• Perform an annual worth evaluation that answers the following questions:

• 1. How much new annual revenue is necessary to recover only the initial investment at an MARR of
10% per year?

• CR is required!
2. The owner conservatively estimates increased income of $5000 per year for all five systems. Is this
project financially viable at the MARR?

• The financial viability could be determined now without calculating the AW value, because the
$5000 in new income is lower than the CR of $5822, which does not yet include the annual costs.
So, the project is not economically justified.

• However, to complete the analysis, determine the total AW. The annual operating costs and
incomes form an arithmetic gradient series with a base of $4350 in year 1, decreasing by $50 per
year for 5 years.

This shows conclusively that the alternative is not financially viable at MARR = 10%.
3. Based on the answer in part (b), determine how much new income PizzaRush must have to
economically justify the project. Operating costs remain as estimated.

An equivalent of the projected $5000 plus the AW amount are necessary to make the project
economically justified at a 10% return. This is 5000 + 1562 = $6562 per year in new revenue. At this
point AW will equal zero.

• EXAMPLE

• 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) the
AW method with a 3-year study period.
Calculating AW values over the respective lives

Y is the better alternative.

• All n values are 3 years and the “salvage values” become the estimated market values after 3 years.

Now X is economically better.

• AW of a Long-Life or Infinite-Life Investment

• The annual worth equivalent of a very long-lived project is the AW value of its capitalized cost
(CC). The AW value of the first cost, P, or present worth, PW, of the alternative uses the same
relation as:

AW= CC(i) = PW(i)

• Cash flows that occur at regular intervals are converted to AW values over one life cycle of their
occurrence. All other non-regular cash flows are first converted to a P value and then multiplied by
i to obtain the AW value over infinity.

• EXAMPLE

• If you receive an inheritance of $10,000 today, how long do you have to invest it at 8% per year to
be able to withdraw $2000 every year forever? Assume the 8% per year is a return that you can
depend on forever.
• Cash flow is shown below . PW indicates that it is necessary to have $25,000 accumulated at the
time that the $2000 annual withdrawals start.

PW = 2000/0.08 = $25,000
Find n = 11.91 years using the relation
$25,000 = 10,000(F/P,8%,n)
• EXAMPLE

• The state is considering three proposals for increasing the capacity of the main drainage canal in an
agricultural region. Proposal A requires dredging the canal. The state is planning to purchase the dredging
equipment and accessories for $650,000. The equipment is expected to have a 10-year life with a $17,000
salvage value. The annual operating costs are estimated to total $50,000. To control weeds in the canal
itself and along the banks, environmentally safe herbicides will be sprayed during the irrigation season.
The yearly cost of the weed control program is expected to be $120,000.

• Proposal B is to line the canal walls with concrete at an initial cost of $4 million. The lining is assumed to
be permanent, but minor maintenance will be required every year at a cost of $5000. In addition, lining
repairs will have to be made every 5 years at a cost of $30,000.

• Proposal C is to construct a new pipeline along a different route. Estimates are an initial cost of $6
million, annual maintenance of $3000 for right-of-way, and a life of 50 years. In table below Compare the
alternatives on the basis of annual worth, using an interest rate of 5% per year.
Thus, Proposal B is selected!