Module 5: Annual Worth Analysis

SI-4251 Ekonomi Teknik

Muhamad Abduh, Ph.D.
Outline Module 5
 Selection of Alternatives with Different Lives
 Salvage Sinking-Fund Method
 Salvage Present Worth Method
 Capital-Recovery-Plus-Interest Method
 AW of a Perpetual Investment

5-2 SI-4251 Ekonomi Teknik Muhamad Abduh, Ph.D.

Selection of Alternatives with Different Lives
1. Selection of investment alternatives can commonly evaluated by comparing their
equivalence-uniform-annual-worth (over the life of the investment)
2. Unlike other method, for evaluating alternatives with different lives, EUAW does not require
comparison over the least common multiple periods.
SV SV SV

O&M R R R R R R R R R
A
0 1 2 3
I I I

I R R R I = Rp. 240 millions

O&M
B O&M
R
= Rp. 25 millions/month
= Rp. 190 millions/4 months
0 1 SV = Rp 75 millions
SV

EUAWA = EUAWB
5-3 SI-4251 Ekonomi Teknik Muhamad Abduh, Ph.D.
Example
 Consider a project with $3000 annual operating
cost and a $5000 investment required each 5 years.
i = 10%

0 1 2 3 4 5

A 1-5 = $3,000
$5,000

For one cycle

EAC = 3000 + 5000(A/P,10%,5) = $4319/yr

5-4 SI-4251 Ekonomi Teknik Muhamad Abduh, Ph.D.

Multiple cycle..same result!

0 1 2 3 4 5 6 7 8 9 10

A 1-10 = $3,000
$5,000
$5,000

For two cycles

EAC = 3000 + 5000 (1+(P|F, .10, 5))(A|P, .10, 10)
= 3000 + 1319 = $4319/yr

5-5 SI-4251 Ekonomi Teknik Muhamad Abduh, Ph.D.

(A) Salvage Sinking-Fund Method
1. Initial investment and salvage value are to be
converted into an equivalent uniform annual value
2. Any other cash flows are to be converted first to
present value (P) or future value (F), then converted
into equivalent uniform annual value
3. Combine all equivalent uniform annual values
P O1
I1 SV

A1

0 1 2 3
EUAW = – P(A/P, i, 36) +SV(A/F, i, 36) – A1 – O1(P/F, i, 9)(A/P, i, 36) + I1(F/P, i, 14)(A/F, i, 36)

5-6 SI-4251 Ekonomi Teknik Muhamad Abduh, Ph.D.

(B) Salvage Present Worth Method
1. Calculate the present worth of salvage value using (P/F) factor,
and subtract that value from the initial cost, P
2. Convert that value (2) into equivalent uniform worth
3. Any other cash flows are to be converted first to present value
(P) or future value (F), then converted into equivalent uniform
annual value
4. Combine all equivalent uniform annual values
P O1
I1 SV

A1

0 1 2 3
EUAW = – [P-SV(P/F, i, 36)](A/P, i, 36) – A1 – O1(P/F, i, 9)(A/P, i, 36) + I1(F/P, i, 14)(A/F, i,
36)
5-7 SI-4251 Ekonomi Teknik Muhamad Abduh, Ph.D.
(C) Capital-Recovery-Plus-Interest Method
1. Subtract the salvage value from initial cost, then convert that value into
equivalent uniform worth
2. Multiply the salvage value by the interest rate
3. Add value obtained from (1) and (2)
4. Any other cash flows are to be converted first to present value (P) or future
value (F), then converted into equivalent uniform annual value
5. Combine all equivalent uniform annual values

P O1
I1 SV

A1

0 1 2 3
EUAW = – (P-SV)(A/P, i, 36) - SV(i) – A1 – O1(P/F, i, 9)(A/P, i, 36) + I1(F/P, i, 14)(A/F, i, 36)

5-8 SI-4251 Ekonomi Teknik Muhamad Abduh, Ph.D.

Example:

S = +$1500
 Cash Flow Diagram is:
A = +$1200/yr

1 2 3 4 5

-$650
-$700
-$750
P=-23,000 -$800
-$850

5-9 SI-4251 Ekonomi Teknik Muhamad Abduh, Ph.D.

Example:
 The Capital Recovery component is:

S = +$1500

1 2 3 4 5

CR(10%) = -23,000(A/P,10%,5) +
1500(A/F,10%,5) = -$5822

P=-23,000

5-10 SI-4251 Ekonomi Teknik Muhamad Abduh, Ph.D.

Example:
 (Revenue – Operating Costs) are:

A = +$1200/yr

1 2 3 4 5

$650
$700
$750
$800
$850

5-11 SI-4251 Ekonomi Teknik Muhamad Abduh, Ph.D.

Example:
 Cost/Revenue component is seen to equal:
1.8101
=+550 –50(A/G,10%,5)
= 550 – 90.50
= $459.50

5-12 SI-4251 Ekonomi Teknik Muhamad Abduh, Ph.D.

Example
 Total Annual worth (CR + Cost/Rev)
 CR(10%) = -$5822
 Revenue/Cost Annual amount: $459.50
 AW(10%) = -$5822+$459.50
 AW(10%) = $5,362.50

This amount would be required to recover the investment and operating costs at the
10% rate on a per year basis

5-13 SI-4251 Ekonomi Teknik Muhamad Abduh, Ph.D.

AW of a Perpetual Investment
 EAC of a perpetual investment

 If an investment has no finite cycle it is called a

perpetual investment. If “P” is the present worth of
the cost of that investment, then EAC is P times i, the
interest P would have earned each year.

EAC=A = P(i)
Remember: P = A/i
From the previous chapter

5-14 SI-4251 Ekonomi Teknik Muhamad Abduh, Ph.D.

Example: Perpetual Investment
 EXAMPLE
Two alternatives are considered for covering a
football field.
The first is to plant natural grass and the second is to
install AstroTurf. Interest rate is 10%/year.
Assume the field is to last a “long time”.

5-15 SI-4251 Ekonomi Teknik Muhamad Abduh, Ph.D.

Example: Continued

Alternative A:
Natural Grass - Replanting will be required each
10 years at a cost of $10,000. Annual cost for
maintenance is $5,000. Equipment must be
purchased for $50,000 which will be replaced after
5 years with a salvage value of $5,000

5-16 SI-4251 Ekonomi Teknik Muhamad Abduh, Ph.D.

Example: Natural Grass

Since cost is predominate, let (+) = cost and (-)

= salvage values

Alternative A: F5 = $5,000 F5 = $5,000

0 1 2 3 4 5 6 7 8 9 10

A = $5,000

$10,000
F5=$50,000
P = $50,000+ $10,000
5-17 SI-4251 Ekonomi Teknik Muhamad Abduh, Ph.D.
Example: Natural Grass: Analysis
 (+) $60,000(A/P,10%,10)
 (+) $5,000 (already an annual cost)
 (+) $50,000(P/F,10%,5)(A/P,10%,10)
 (-) $5,000(P/F,10%,5)(A/P,10%,10)
 (+) $10,000(A/F,10%,10)
 (-) $5,000(A/F,10%,10)
 = $ 19,046/year

5-18 SI-4251 Ekonomi Teknik Muhamad Abduh, Ph.D.

Example: Artificial Carpet (Surface)
 A = P(i) for a perpetual life project
 Annual Cost of Installation:
 =$150,000 (.10) = $15,000/ year
 Annual Maintenance = $5,000/year

 Total: $15,000 + $5,000 = $20,000/Yr

 Choose A, cost less per year!

5-19 SI-4251 Ekonomi Teknik Muhamad Abduh, Ph.D.

Comparing Alternatives by EUAW
Exercise:
Two types of production systems are being considered based on interest rate of 9% and
the following characteristics:

system A system B
Initial cost Rp 860.000.000,- Rp 1.360. 000.000,-
Annual O & M expenses Rp 89.000.000,- Rp 73.000.000.-
Annual receipts Rp 121.500.000,- Rp 133.400.000,-
Salvage value Rp 200.000.000,- Rp 320.000.000,-
Life 6 years 10 years

(A/P, 9%, 6) = 0.21632 (A/P, 9%, 10) = 0.14903

(A/F, 9%, 6) = 0.13632 (A/F, 9%, 10) = 0.06903
(P/F, 9%, 6) = 0.60320 (P/F, 9%, 10) = 0.46320
5-20 SI-4251 Ekonomi Teknik Muhamad Abduh, Ph.D.
 Homework #5
1. A manufacturing company is trying to decide among three different pieces of equipment that
have the following characteristics:

equipment A equipment B equipment C

First cost Rp. 975.000.000,- Rp. 854.500.000,- Rp. 1.025.000.000,-
Annual M&O cost Rp. 89.700.000,- Rp. 95.000.000,- Rp. 75.000.000,-
Salvage value Rp. 161.000.000,- Rp. 205.000.000,- Rp. 321.000.000,-
Overhaul cost Rp. 175.000.000,- / 2 years Rp. 135.000.000,- / 3 years Rp. 175.000.000,- / 3 years

useful life = 6 years and interest rate of 12%

2. Which of these two machines that have the following costs is to be selected for a continuous
production process, if the i = 15% p.a:
machine X machine Y
First cost Rp. 3.800.000.000,- Rp. 1.675.000.000,-
Annual operating cost Rp. 289.700.000,- Rp. 315.000.000,-
Salvage value Rp. 461.000.000,- Rp. 205.000.000,-
Life 5 years 3 years

5-21 SI-4251 Ekonomi Teknik Muhamad Abduh, Ph.D.