Chapter 7

Annual Worth Analysis

Principles of Engineering Economic Analysis, 5th edition

 Systematic Economic Analysis Technique
1. Identify the investment alternatives
2. Define the planning horizon
3. Specify the discount rate
4. Estimate the cash flows
5. Compare the alternatives
6. Perform supplementary analyses
7. Select the preferred investment

Principles of Engineering Economic Analysis, 5th edition

 Annual Worth Analysis

Single Alternative

Principles of Engineering Economic Analysis, 5th edition

 Annual Worth Method
converts all cash flows to a uniform annual series
over the planning horizon using i=MARR
a popular DCF method

 n   i (1  i ) n

AW (i %)   At (1  i )  
t

  (1  i )  1
n
 t 0
AW (i %)  PW (i %) ( A | P i %, n)

Principles of Engineering Economic Analysis, 5th edition

 Example 7.1
A $500,000 investment in a surface mount placement
machine is being considered. Over a 10-year planning
horizon, it is estimated the SMP machine will produce net
annual savings of $92,500. At the end of 10 years, it is
estimated the SMP machine will have a $50,000 salvage
value. Based on a 10% MARR and annual worth analysis,
should the investment be made?

AW(10%) = -$500K(A|P 10%,10) + $92.5K

+ $50K(A|F 10%,10)
= $14,262.50
=PMT(10%,10,500000,-50000)+92500
= $14,264.57

Principles of Engineering Economic Analysis, 5th edition

 Example 7.2
How does annual worth change over the life of the
investment? How does annual worth change when
the salvage value decreases geometrically and as a
gradient series?

Principles of Engineering Economic Analysis, 5th edition

Principles of Engineering Economic Analysis, 5th edition
Principles of Engineering Economic Analysis, 5th edition
 Annual Worth Analysis

Multiple Alternatives

Principles of Engineering Economic Analysis, 5th edition

 Example 7.4
Recall the example involving two alternative designs for a
new ride at a theme park: Alt. A costs $300,000, has net
annual after-tax revenue of $55,000, and has a negligible
salvage value at the end of the 10-year planning horizon; Alt.
B costs $450,000, has revenue of $80,000/yr., and has a
negligible salvage value. Based on an AW analysis and a
10% MARR, which is preferred?

AWA(10%) = -$300,000(A|P 10%,10) + $55,000

= -$300,000(0.16275) + $55,000 = $6175.00
=PMT(10%,10,300000)+55000 = $6176.38
AWB(10%) = -$450,000(A|P 10%,10) + $80,000
= -$450,000(0.16275) + $80,000 = $6762.50
=PMT(10%,10,450000)+80000 = $6764.57

Analyze the impact on AW based on salvage values

decreasing geometrically to 1¢ after 10 years.
Principles of Engineering Economic Analysis, 5th edition
Principles of Engineering Economic Analysis, 5th edition
 AW(A) AW(B)

$40,000

$30,000
AW(A) = AW(B) when
$20,000 MARR = 10.56%

$10,000

$0
0%

2%

4%

6%

8%

10%

12%

14%

16%

18%

20%
-$10,000

-$20,000

-$30,000
MARR

Principles of Engineering Economic Analysis, 5th edition

 Example 7.5
For The Scream Machine alternatives (A costing $300,000,
saving $55,000, and having a negligible salvage value at the
end of the 10-year planning horizon; B costing $450,000,
saving $80,000, and having a negligible salvage value),
using an incremental AW analysis and a 10% MARR, which
is preferred?

AWA(10%) = -$300,000(A|P 10%,10) + $55,000

= -$300,000(0.16275) + $55,000 = $6175.00
=PMT(10%,10,300000)+55000 = $6176.38 > $0
(A is better than “do nothing”)
AWB-A(10%) = -$150,000(A|P 10%,10) + $25,000
= -$150,000(0.16275) + $25,000 = $587.50
=PMT(10%,10,150000)+25000 = $588.19 > $0
(B is better than A)
Prefer B
Principles of Engineering Economic Analysis, 5th edition
 Example 7.6
If an investor’s MARR is 12%, which mutually exclusive
investment alternative maximizes the investor’s future worth,
given the parameters shown below?

EOY CF(1) CF(2) CF(3)

0 -$10,000 -$14,500 -$20,000
1 $5,000 $5,000 $0
2 $5,000 $5,000 $3,000
3 $10,000 $5,000 $6,000
4 $5,000 $9,000
5 $5,000 $12,000
6 $7,500 $15,000

Consider 3 scenarios: individual life cycles; least common

multiple of lives; and “one-shot” investments

Principles of Engineering Economic Analysis, 5th edition

 Example 7.6 (Continued)
Scenario 1: individual life cycles

AW1(12%) = -$10,000(A|P 12%,3) + $5000 + $5000(A|F 12%,3)

= $2318.25
=PMT(12%,3,10000,-5000)+5000 = $2318.26
AW2(12%) = -$14,500(A|P 12%,6) + $5000 +$2500(A|F 5%,6)
= $1473.17
=PMT(12%,6,14500,-2500)+5000 = $1473.23
AW3(12%) = -$20,000(A|P 12%,6) + $3000(A|G 12%,6)
= $1651.55
=PMT(12%,6,-1000*NPV(12%,0,3,6,9,12,15)+20000)
= $1651.63

Principles of Engineering Economic Analysis, 5th edition

 Example 7.6 (Continued)
Scenario 2: least common multiple of lives
EOY CF(1') CF(2) CF(3)
0 -$10,000 -$14,500 -$20,000
1 $5,000 $5,000 $0
2 $5,000 $5,000 $3,000
3 $0 $5,000 $6,000
4 $5,000 $5,000 $9,000
5 $5,000 $5,000 $12,000
6 $10,000 $7,500 $15,000

AW1(12%) = -$10,000(A|P 12%,6) + $5000 + $5000(A|F 12%,6)

- $5000(A|P 12%,3)(A|P 12%,6)
= $2318.22
=PMT(12%,6,10000,-5000)+5000
+PMT(12%,6,PV(12%,3,,-5000))= $2318.26
AW2(12%) = $1473.17 = $1473.23
AW3(12%) = $1651.55 = $1651.63
Principles of Engineering Economic Analysis, 5th edition
 Example 7.6 (Continued)
Scenario 3: “one-shot” investments
EOY CF(1) CF(2) CF(3)
0 -$10,000 -$14,500 -$20,000
1 $5,000 $5,000 $0
2 $5,000 $5,000 $3,000
3 $10,000 $5,000 $6,000
4 $0 $5,000 $9,000
5 $0 $5,000 $12,000
6 $0 $5,000 $15,000

AW1(12%) = {-$10,000 + [$5000(P|A 12%,3)

+ $5000(P|F 12%,3)]}(A|P 12%,6) = $1354.32
=PMT(12%,6,10000-PV(12%,3,-5000,-5000))
= $1354.29
AW2(12%) = $1473.17 = $1473.23
AW3(12%) = $1651.55 = $1651.63
Principles of Engineering Economic Analysis, 5th edition
 Considering scenarios 1 and 2, is it
reasonable to assume an investment
alternative equivalent to Alt. 1 will be
available in 3 years? If so, why was
the MARR set equal to 12%?

Principles of Engineering Economic Analysis, 5th edition

 Example 7.7
Three industrial mowers (Small, Medium, and Large) are
being evaluated by a company that provides lawn care
service. Determine the economic choice, based on the
following cost and performance parameters:
Small Medium Large
First Cost: $1,500 $2,000 $5,000
Operating Cost/Hr $35 $50 $76
Revenue/Hr $55 $75 $100
Hrs/Yr 1,000 1,100 1,200
Useful Life (Yrs) 2 3 5

Use AW analysis to determine the preferred mower, based on

a MARR of 12%.

Principles of Engineering Economic Analysis, 5th edition

 Example 7.7 (Continued)
AWsmall = -$1500(A|P 12%,2) + $20(1000) = $19,112.45
=PMT(12%,2,1500)+20*1000 = $19,112.45

AWmed = -$2000(A|P 12%,3) + $25(1100) = $26,667.30

=PMT(12%,3,2000)+25*1100 = $26,667.30

AWlarge = -$5000(A|P 12%,5) + $24(1200) = $27,412.95

=PMT(12%,5,5000)+24*1200 = $27,412.95

What did we assume when solving the example?

Principles of Engineering Economic Analysis, 5th edition

 Example 7.8
If a 5-year planning horizon were used, what salvage values
are required to have the same AW as before? The small
mower will be replaced at the end of year 4; the medium
mower will be replaced at the end of year 3. One year of
service of the small mower will have the following cash flows:

SVsmall = $19,112.45(F|A 12%,1) - $20,000(F|A 12%,1)

+ $1500(F|P 12%,1) = $792.45
=FV(12%,1,-19112.45)-FV(12%,1,-20000,1500)
= $792.45
SVmed = $26,667.30(F|A 12%,2) - $27,500(F|A 12%,2)
+ $2000(F|P 12%,2) = $743.48
=FV(12%,2,-26667.3)-FV(12%,2,-27500,2000)
= $743.48
SVlarge = $0
Principles of Engineering Economic Analysis, 5th edition
 Example 7.9
Suppose a 6-yr planning horizon is used and the large mower
is continued in service for an additional year at a penalty of a
15% increase in operating cost the 6th year. Which mower is
preferred?

AWsmall = $19,112.45
From Example 7.7
AWmed = $26,667.30

AWlarge = -$5000(A|P 12%,6) + $24(1200)

- 0.15($76)(1200)(A|F 12%,6) = $25,898.06
=PMT(12%,6,5000,.15*76*1200)+24*1200
= $25,898.14

Principles of Engineering Economic Analysis, 5th edition

 Example 7.10
Suppose a 6-yr planning horizon is used and a large mower is
leased for the 6th year at a $1500 beginning of year cost and
an end of year operating cost of $77. Which mower is
preferred?

AWsmall = $19,704.15
From Example 7.7
AWmed = $26,667.30

AWlarge = -$5000(A|P 12%,6) + $24(1200)

- [$1(1200) + $1500(F|P 12%,1)](A|F 12%,6)
= $27,228.95
=PMT(12%,6,5000,1200-FV(12%,1,,1500))
+24*1200
= $27,228.98
Principles of Engineering Economic Analysis, 5th edition
 Capital Recovery Cost

Principles of Engineering Economic Analysis, 5th edition

 CFD for Capital Recovery Cost (CR).

$F

≡
0 1 2 n -1 n 0 1 2 n -1 n
End of Year

$CR $CR $CR $CR

$P

CR = P(A|P i,n) – F(A|F i, n)

Remember: (A|F i, n)= (A|P i,n) - i

Principles of Engineering Economic Analysis, 5th edition

 Capital Recovery Cost Formulas

CR = P(A|P i,n) – F(A|F i, n)

CR = (P-F)(A|F i, n) + Pi
CR = (P-F)(A|P i,n) + Fi
CR =PMT(i,n,-P,F)

Example
P = $500,000 F = $50,000 i = 10% n = 10 yrs
CR = $500,000(0.16275) - $50,000(0.06275) = $78,237.50
CR = $450,000(0.06275) + $500,000(0.10) = $78,237.50
CR = $450,000(0.16275) + $50,000(0.10) = $78,237.50
CR =PMT(10%,10,-500000,50000) = $78,235.43
Principles of Engineering Economic Analysis, 5th edition
 Pit Stop #7—No Time to Coast
1. True or False: Annual worth analysis is the most popular DCF
measure of economic worth.
2. True or False: Unless non-monetary considerations dictate
otherwise, choose the mutually exclusive investment alternative that
has the greatest annual worth over the planning horizon.
3. True or False: The capital recovery cost is the uniform annual cost
of the investment less the uniform annual worth of the salvage
value.
4. True or False: If AW > 0, then PW>0, and FW>0.
5. True or False: If AW(A) > AW(B), then PW(A) > PW(B).
6. True or False: If AW (A) < AW(B), then AW(B-A) > 0.
7. True or False: If AW(A) > AW(B), then CW(A) > CW(B) and DPBP(A) <
DPBP(B).
8. True or False: AW can be applied as either a ranking method or as
an incremental method.
9. True or False: To compute capital recovery cost using Excel, enter
=PMT(i%,n,-P,F) in any cell in a spreadsheet.
10. True or False: When using annual worth analysis with mutually
exclusive alternatives having unequal lives, always use a planning
horizon equal to the least common multiple of lives.

Principles of Engineering Economic Analysis, 5th edition

 Pit Stop #7—No Time to Coast
1. True or False: Annual worth analysis is the most popular DCF
measure of economic worth. FALSE
2. True or False: Unless non-monetary considerations dictate
otherwise, choose the mutually exclusive investment alternative that
has the greatest annual worth over the planning horizon. TRUE
3. True or False: The capital recovery cost is the uniform annual cost
of the investment less the uniform annual worth of the salvage
value. TRUE
4. True or False: If AW > 0, then PW > 0, and FW > 0. TRUE
5. True or False: If AW(A) > AW(B), then PW(A) > PW(B). TRUE
6. True or False: If AW (A) < AW(B), then AW(B-A) > 0. TRUE
7. True or False: If AW(A) > AW(B), then CW(A) > CW(B) and DPBP(A) <
DPBP(B). FALSE
8. True or False: AW can be applied as either a ranking method or as
an incremental method. TRUE
9. True or False: To compute capital recovery cost using Excel, enter
=PMT(i%,n,-P,F) in any cell in a spreadsheet. TRUE
10. True or False: When using annual worth analysis with mutually
exclusive alternatives having unequal lives, always use a planning
horizon equal to the least common multiple of lives. FALSE

Principles of Engineering Economic Analysis, 5th edition