Annual Cash Flow Analysis

Chapter 6:
 Techniques for Cash Flow Analysis
 Annual Cash Flow Analysis:
 Analysis Period = Alternative Lives
 Analysis Period = Common Multiple of Alt. Lives
 Analysis Period for a Continuing Requirement
 Infinite Analysis Period

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Techniques for Cash Flow Analysis

 Present Worth Analysis

 Annual Cash Flow Analysis
 Rate of Return Analysis
 Future Worth Analysis
 Benefit-Cost Ratio Analysis
 Payback Period Analysis

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Annual Cash Flow Calculations Resolving a Present
Cost to an Annual Cost

 Simplest case is to convert the PV to a series of EUAW

(equivalent uniform annual worth) cash flows –
[previously A].
• A=P(A/P,i,n)

 Where there is salvage value

• A will be reduced
• A = F(A/F,i,n)

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 Annual Cash Flow
Three Essential Points

1. EUAW = PW(A/P,i,n)
2. EUAW is
• Decreased by a cost
• Increased by a benefit
3. For an irregular cash flow over the analysis period,
first determine the PW then convert to EUAW

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 Annual Cash Flow Analysis

Situation Criterion
Fixed input Amount of Maximize
capital available EUAW
fixed
Fixed output $ amount of Maximize
benefit is fixed EUAW
Neither fixed Neither capital Maximize
nor $ benefits EUAW
are fixed

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 Techniques for Cash Flow Analysis SA

A A A A
Present Worth Analysis:
PVA(0)=-RA+A(P/A,i,n)+SA(P/F,i,n)

PVB(0)=-RB+B(P/A,i,n)+SB(P/F,i,n) 0 1 2 3 … n
If PVA(0)>PVB(0) => choose A, RA B B B B
otherwise => choose B. SB
Annual Cash Flow Analysis:
EUACA=RA(A/P,i,n) EUABA=A+SA(A/F,i,n) 0 1 2 3 … n
(EUAB-EUAC)A=A+SA(A/F,i,n)- RA(A/P,i,n) RB

(EUAB-EUAC)B=B+SB(A/F,i,n)- RB(A/P,i,n)
(EUAB-EUAC)A (EUAB-EUAC)A (EUAB-EUAC)B (EUAB-EUAC)B
If (EUAB-EUAC)
(EUAB-EUAC)
A A>(EUAB-EUAC)
(EUAB-EUAC) (EUAB-EUAC)B
A
=> choose A, otherwise
A (EUAB-EUAC) =>(EUAB-EUAC)
choose B.
B B (EUAB-EUAC)B

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0 1 2 3 … n 0 1 2 3 … n
Analysis Period Considerations

1. Analysis period equal to alternative lives

2. Analysis period a common multiple of alternative lives
3. Analysis period for a continuing requirement
4. Some other period such as project life

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 Analysis Period Equals to Alternative Lives

 When the analysis period for an economy study is the

same as the useful life for each alternative, we have an
ideal situation. There are no difficulties. The economy
study can be based on the analysis period
 Base the comparison on the life of the alternatives
 This is the case we have most often considered in our
examples
 This is rarely the case in “real-life” organizations

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 Analysis Period = Common Multiple of Alternative Lives

Example Two pumps are being considered for purchase. If interest is 7%, which pump should be
bought. $1,500
Assume that Pump B will be replaced after its useful life by the same one

0 1 2 3 4 5 6 7 8 9 10 11 12
Pump A B
$7,000
Initial Cost $7,000 $5,000 $1,000 $1,000
End-of-Useful-Life Salvage Value $1,500 $1,000
Useful life, in years 0 1 2 3 4 5 6 7 8 9 10 11 12
12 6
$5,000
$5,000 replace B
EUACA = $7,000 (A/P, 7%, 12) - $1,500 (A/F, 7%, 12)

EUACB = $5,000 (A/P, 7%, 6) - $1,000 (A/F, 7%, 6)

EUACA = $797 EUACB = $909

Under the circumstances of identical replacement, it is appropriate to compare the annual cash flows computed
for alternatives based on their own different service lives (12 years, 6 years).
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 Analysis Period for a Continuing Requirement

Many times the economic analysis is to determine how to provide for a more or less
continuing requirement. There is no distinct analysis period. The analysis period is
undefined. In case when alternatives were compared based on PW analysis, the least
common multiple of alternative lives was found, and present worth for that time is
calculated. In case alternatives are compared based on annual cash flow analysis, it is
appropriate to compare the annual cash flows computed for alternatives based on their
own different service lives.

Example
Pump A B
Initial Cost $7,000 $5,000
End-of-Useful-Life $1,500 $1,000
Salvage Value
Useful life, in years 12 9

EUACA = $797

EUACB = $684

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 Infinite Analysis Period
Alternative A B C
Motivating Example
Consider the following three Cost $100.00 $150.00 $200.00
mutually exclusive alternatives: Uniform Annual Benefit $10.00 $17.62 $55.48
Useful Life, in years Infinity 20 5

Assuming that Alternatives B and C are replaced with identical replacements at the end of
their useful lives, and an 8% interest rate, which alternative should be selected?

Case 1. We have alternatives with limited (finite) lives in an infinite analysis period situation:
 
If we assume identical replacement (all replacements have identical cost, performance,
etc.) then we will obtain the same EUAC for each replacement of the limited-life
alternative. The EUAC for the infinite analysis period is therefore equal to the EUAC for
the limited life situation. With identical replacement:

EUACfor infinite analysis period = EUAC for limited life n

EUACB= $150(A/P,8%,20) - $17.62 EUACC= $200(A/P,8%,5) - $55.48

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 Infinite Analysis Period

Case 2. Another case occurs when we have an alternative with an infinite life in a problem
with an infinite analysis period. In this case,
 
EUACfor infinite analysis period = P (A/P,i,) + any other annual (costs-benefits)

Alternative A B C
Cost $100.00 $150.00 $200.00
(A/P,i,) = i
Uniform Annual Benefit $10.00 $17.62 $55.48
Useful Life, in years Infinity 20 5

EUACA= $100(A/P,8%,) - $10.00 = $100 *0.08 - $10.00 = $-2.00

EUACB= $150(A/P,8%,20) - $17.62 = $150*0.1019- $17.62 =$-2.34
EUACC= $200(A/P,8%,5) - $55.48 = $200*2.505 - $55.48 =$-5.38

The most general case for annual cash flow analysis is when the analysis period and the lifetimes of
the alternatives of interest are all different. In this case, terminal values at the end of the analysis
period become very important.

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