SM 300

Engineering Economics
Selection Guidelines for Annual Worth Analysis
Mutually Exclusive (ME) Alternative Evaluation by
Annual Worth (AW)
A company is considering two machines.
Machine X has a first cost of $30,000, Average Operating Cost
(AOC) of $18,000, and Salvage of $7000 after 4 years.
Machine Y will cost $50,000 with an AOC of $16,000 and Salvage of
$9000 after 6 years.
Which machine should the company select at an interest rate of
12% per year?
Solution:
AWX = -30,000(A/P,12%,4) –18,000 +7,000(A/F,12%,4)
= $-26,412
AWY = -50,000(A/P,12%,6) –16,000 + 9,000(A/F,12%,6)
= $-27,052
Select Machine X; it has the numerically larger AW value
Note: For AW there is already an assumption that the services of
the alternative is needed for the LCM period.
 Capitalized Cost (CC) Analysis
CC refers to the present worth of a project with a very
long life, that is, PW as n becomes infinite
A
Basic equation is: CC = P = i
“A” essentially represents the interest on a perpetual investment
Note: The factor (P/A, i,∞) = 1/i
For example, in order to be able to withdraw $50,000 per year
forever at i = 10% per year, the amount of capital required is
50,000/0.10 = $500,000

For finite life alternatives, convert all cash flows into an A

value over one life cycle and then divide by i
➔ Assumption that the same alternative will continue for
infinite life cycles
 Example: Capitalized Cost
Compare the machines shown below on the basis of their
capitalized cost. Use i = 10% per year
Machine 1 Machine 2
First cost,$ -20,000 -100,000
Annual cost,$/year -9000 -7000
Salvage value, $ 4000 -----
Life, years 3 ∞
Solution:
Convert cash flows into A and then divide by i
A1 = -20,000(A/P,10%,3) – 9000 + 4000(A/F,10%,3) = $-15,834
CC1 = -15,834 / 0.10 = $-158,340 Note: (A/P, i, infinity) = i
Hence,
A2 = -100,000 (A/P, 10%, ∞ ) - 7000 A2 = -100,000 * i - 7000
CC2 = -100,000 – 7000/ 0.10 = $-170,000 and
Select machine 1 CC2 = A2 / i
 AW of Permanent Investment
Use A = Pi for AW of infinite life alternatives
Find AW over one life cycle for finite life alternatives

Compare the alternatives below using AW and i = 10% per year

C D
First Cost, $ -50,000 -250,000
Annual operating cost, $/year -20,000 -9,000
Salvage value, $ 5,000 75,000
Life, years 5 ∞
Solution: Find AW of C over 5 years and AW of D using relation A = Pi
AWC = -50,000(A/P,10%,5) – 20,000 + 5,000(A/F,10%,5)
= $-32,371
Note:
AWD = Pi + AOC = -250,000(0.10) – 9,000 (A/P, i, infinity) = i
= $-34,000 And
Select alternative C (A/F, i, infinity) = 0
 Capital Recovery (CR) and Annual Worth (AW)
Capital recovery (CR) is the equivalent annual amount that an asset, process,
or system must earn (new revenue) each year to just recover the first cost
plus a stated rate of return over its expected life. Salvage value is
considered when calculating CR. [Note: Annual operating costs (AOC) are
not included]
CR = -P(A/P,i%,n) + S(A/F,i%,n)
Example:
An asset has a first cost of $20,000, an annual operating cost of $8000 and a
salvage value of $5000 after 3 years. (At i =10%)
[Note: Annual Operating Cost (AOC) not included in CR ]
CR = -20,000(A/P,10%,3) + 5000(A/F,10%,3) = $ – 6532 per year
i.e. Net revenue from the asset for 3 years must be at least $6532 per year
to recover initial investment and 10% p.a. rate of return.
Then, AW = CR + AOC (along with sign)
AW = – 6532 – 8000 = $ – 14,532
 ROR Analysis
for
Comparing Alternate Economic
Proposals
 Why use ROR for Comparing Alternative Investment Options?

The PW, FW and AW methods used so far to compare the

alternatives assumed that the value of i was known.
In real world i fluctuates widely depending upon various factors
like:
➢ Who is the investor (individual, corporation, government
agency)
➢ How much money is being invested.
➢ How long the money can be committed.
➢ The credit rating of the investor.
Thus, it may be wise and advantageous to analyze a cash flow of
alternative investment to determine what 'i' it yields and
compare it to possible available i in real world.
 Rate of Return Analysis- ROR Calculation and
Project Evaluation
• To determine ROR, find the i* value in the relation
PW = 0 or AW = 0 or FW = 0
• Alternatively, a relation like the following finds i*
PWoutflow = PWinflow [Without sign]
• Note: ROR may also be called as Internal Rate of Return
(IROR) since the resulting interest rate depends only on
the cash flows themselves

• For evaluation, a project is economically viable if

i* ≥ MARR
 ROR Calculation Using PW, AW or FW Relation
ROR is the unique i* rate at which a PW, FW, or AW
relation equals exactly 0

Steps

• Set PW/AW/FW = 0 and solve by trial‐and‐error

• If PW/AW/FW > 0, i* needs to be higher; else i* needs
to be lower
• Once you’ve bracketed the solution, use linear
interpolation to get the actual value of i*
 ROR Calculation Using PW, FW or AW Relation
ROR is the unique i* rate at which a PW, FW, or AW relation equals
exactly 0
Example 1: Consider the following cash flow and compute the ROR
using a present worth equation. [Note: There is only ONE sign
change in net cash flow and hence only one ROR value]
Year 0 1 2 3 4 5
Net Cash Flow -1,000 0 0 +500 0 +1,500
Solution:
PWreceipts + PWdisbursements = 0
500(P/F,i%,3) + 1,500(P/F,i%,5) – 1,000 = 0
By trial and error:
i = 16%: 500(0.6407) + 1,500(0.4761) – 1,000 = 34.5 > 0 ➔ i > 16%
i = 18%: 500(0.6086) + 1,500(0.4371) – 1,000 = -40.05 < 0
By interpolation
0 = 34.5 + (i – 16)/(18 – 16) (-40.05 – 34.5)
i=16.9%
 ROR Calculation Using PW- Example 2
Consider the following cash flow and compute the ROR using a
present worth equation. [Note: There is only ONE sign change in net
cash flow and hence only one ROR value]
Year 0 1 to 10 10
Net Cash Flow -$5,000 $100 $7,000
Solution:
PWreceipts + PWdisbursements = 0
100(P/A,i%,10) + 7,000(P/F,i%,10) – 5,000 = 0
By trial and error:
For i=5%: 100(7.7217) + 7,000(0.6139) – 5,000 = 69.47 > 0 ➔ i > 5%
For i=6%: 100(7.3601) + 7,000(0.5584) – 5,000 = -355.19 < 0
By interpolation
0 = 69.47 + (i – 5)/(6 – 5) (-355.19 – 69.47)
i=5.16%
 ROR Calculation Using AW- Same Example 2
Consider the following cash flow and compute the ROR using a
annual worth equation. [Note: There is only ONE sign change in net
cash flow and hence only one ROR value]
Year 0 1 to 10 10
Cash Flow -$5,000 $100 $7,000
Solution:
AWreceipts + AWdisbursements = 0
100 + 7,000 (A/F,i%,10) – 5,000 (A/P,i%,10) = 0
By trial and error:
For i=5%: 100 + 7,000(0.0795) –5,000(0.12950) = 9 > 0 ➔ i > 5%
For i=6%: 100 + 7,000(0.07587) –5,000(0.13587) = -48.26 < 0
By interpolation
0 = 9 + (i – 5)/(6 – 5) (-48.26 – 9)
i=5.157% ~ 5.16% [Same as PW method]
 ROR Calculation Using PW Relation
Example 3:
An investment of $20,000 in new equipment will generate
income of $7000 per year for 3 years, at which time the
machine can be sold for an estimated $8000. If the
company’s MARR is 15% per year, should it buy the
machine?
Solution:: The ROR equation, based on a PW relation, is:
0 = -20,000 + 7000(P/A,i*,3) + 8000(P/F, i*,3)

Solve for i* by trial and error.

Let first i* be at MARR 15%
i* = 18.2% per year
Since i* > MARR = 15%, the company should buy the machine
 Conventional and Nonconventional Cash Flows
• For some cash flow series (net for one project or incremental for
two alternatives) it is possible that more than one unique rate of
return i* exists.
• This is referred to as multiple i* values.
• It is difficult to complete the economic evaluation when multiple
i* values are present, since none of the values may be the correct
rate of return.
• In actuality, finding the rate of return is solving for the root(s) of
an nth order polynomial.
• Conventional or simple cash flows have only one sign change
over the entire series. Commonly, this is negative in year 0 to
positive at some time during the series. There is a unique, real
number i* value for a conventional series.
• A nonconventional series has more than one sign change and
multiple roots may exist.
Conventional and Nonconventional Cash Flows (Contd.)
 Multiple ROR Values
Multiple i* values may exist when there is more than one sign
change in net cash flow (NCF) series.
Such CF series are called non-conventional
Two tests for multiple i* values:
Descarte’s rule of signs: Total number of real i* values is ≤ the
number of sign changes in net cash flow series.
Norstom’s criterion: There is one real-number, positive i* value if
the cumulative cash flow series S0, S1, . . . , Sn changes sign only once
and S0 < 0. Note:
➢ If cumulative amount in the end is zero, i=0% trivially solves the
problem
➢ -,0,0,…,0,+ (or) +,0,0,…,- is ONE sign change.
➢ Norstom’s Criteria is only a sufficient condition, not necessary.
▪ IF it is satisfied THEN there exists a unique positive root.
▪ IF it is not satisfied … there still may be a unique positive root !
Example: Net cash flow of {-1,2,-2,4} has a unique i*=1, although the
cumulative cash flow {-1,1,-1,3} changes sign three times.