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6.Different-life Analysis - Example

The document discusses various financial evaluation methods for capital investments, including Present Worth (PW), Future Worth (FW), and Capitalized Cost (CC), emphasizing their application in large public projects. It outlines procedures for calculating CC and Annual Worth (AW) for both recurring and nonrecurring costs, providing examples for clarity. The document concludes with guidelines for selecting alternatives based on lower CC and AW values, highlighting the importance of life-cycle cost analysis in decision-making.

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anjurishi141
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4 views

6.Different-life Analysis - Example

The document discusses various financial evaluation methods for capital investments, including Present Worth (PW), Future Worth (FW), and Capitalized Cost (CC), emphasizing their application in large public projects. It outlines procedures for calculating CC and Annual Worth (AW) for both recurring and nonrecurring costs, providing examples for clarity. The document concludes with guidelines for selecting alternatives based on lower CC and AW values, highlighting the importance of life-cycle cost analysis in decision-making.

Uploaded by

anjurishi141
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPTX, PDF, TXT or read online on Scribd
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Different-life Analysis - Example

For 18 years at MARR = 15%: PWA = $-45,036


For 18 years at MARR = 15%: PWB = $-41,384
Select location B
Note: Selection changed from 5-year study period
Future Worth Evaluation
• FW evaluation of alternatives is especially
applicable for LARGE capital investment
situations when maximizing the future worth of a
corporation is important
• e.g., buildings, power generation, acquisitions

• Evaluation approach: Determine FW value from


cash flows or PW with an n value in F/P factor
 equal to study period, or
 equal to LCM of alternatives’ lives
Capitalized Cost (CC)
• PW of alternative that will last ‘forever’
• Especially applicable to public project
evaluation (dams, bridges, irrigation,
hospitals, police, etc.)
• CC relation is derived using the limit as
n → ∞ for the P/A factor
PW = A(P/A,i%,n) =

PW = A[1/i ]
Capitalized Cost
• Refer to PW as CC when n is large (can be
considered infinite). Then

and AW = CC × i
Example: If $10,000 earns 10% per year, $1,000 is interest
earned annually for eternity. Principal remains in tact

• Cash flows for CC computations are of two


types -- recurring and nonrecurring
Capitalized Cost
Procedure to find CC
1. Draw diagram for 2 cycles of recurring cash
flows and any nonrecurring amounts
2. Calculate PW (CC) for all nonrecurring
amounts
3. Find AW for 1 cycle of recurring amounts; then
add these to all A series applicable for all years
1 to ∞ (or long life)
4. Find CC for amount above using CC = AW/i
5. Add all CC values (steps 2 and 4)
CC Computation - Example
Find CC and A values at i = 5% of long-term public
project with cash flows below. Cycle time is 13
years.
Nonrecurring costs: first $150,000; one-time of $50,000 in year 10
Recurring costs: annual maintenance of $5000 (years 1-4) and
$8000 thereafter; upgrade costs $15,000 each 13 years

Step 1

(cont →)
CC Computation - Example
2. CC of nonrecurring costs:
CC1 = -150,000 – 50,000(P/F,5%,10) = $-180,695
3. AW of recurring $15,000 upgrade:
AW = -15,000(A/F,5%,13) = $-847 per year
AW of recurring maintenance costs years 1 to ∞:
AW = $-5000 per year forever
4. CC of extra $3000 maintenance for years 5 to ∞:
CC2 = -3000(P/F,5%,4)/0.05 = $-49,362
CC for recurring upgrade and maintenance costs:
CC3 = (-847-5000)/0.05 = $-116,940
5. Total CC obtained by adding all three CC components
CCT = -180,695 – 49,362 – 116,940 = $-346,997
The AW value is the annual cost forever:
AW = CC × i = -346,997(0.05) = $-17,350
CC Evaluation of Alternatives

• For two long-life or infinite-life alternatives:


SELECT ALTERNATIVE WITH LOWER CC OF COSTS

• For one infinite life and one finite life:


Determine CC for finite life alternative using
AW of 1 life cycle and relation CC = AW/i
SELECT ALTERNATIVE WITH LOWER CC OF COSTS
CC Evaluation of Alternatives - Example
1 long-term (assumed infinite); 1 finite life
Long-term alternative (LT): $8 million now; $25,000
renewal annual contract
Short-term alternative (ST): $2.75 million now;
$120,000 AOC; life is n = 5 years
Select better at MARR = 15% per year

CCLT = -8,000,000 – 25,000/0.15 = $-8.17 million


CCST = AW/0.15
= [-2,750,000(A/P,15%,5) – 120,000]/0.15
= $-6.27 million
Conclusion: Select ST with lower CC of costs
Annual
Worth
Analysis
LEARNING OUTCOMES

1.Advantages of AW
2.Capital Recovery and AW
values
3.AW analysis
4.Perpetual life
5.Life-Cycle Cost analysis
Advantages of AW Analysis

AW calculated for only one life cycle

Assumptions:
Services needed for at least the LCM of lives of alternatives
Selected alternative will be repeated in succeeding life cycles
in same manner as for the first life cycle
All cash flows will be same in every life cycle (i.e., will change
by only inflation or deflation rate)
Alternatives usually have the following
cash flow estimates
Initial investment, P – First cost of an asset
Salvage value, S – Estimated value of asset at end of
useful life
Annual amount, A – Cash flows associated with asset, such

as annual operating cost (AOC), etc.


Relationship between AW, PW and FW
AW = PW(A/P,i%,n) = FW(A/F,i%,n)
n is years for equal-service comparison (value of LCM or
specified study period)
Calculation of Annual Worth
AW for one life cycle is the same for all life cycles!!

An asset has a first cost of $20,000, an annual operating


cost of $8000 and a salvage value of $5000 after 3 years.
Calculate the AW for one and two life cycles at i = 10%

AWone = - 20,000(A/P,10%,3) – 8000 + 5000(A/F,10%,3)


= $-14,532
AWtwo = - 20,000(A/P,10%,6) – 8000 – 15,000(P/F,10%,3)(A/P,10%,6)
+ 5000(A/F,10%,6)
= $-14,532
Capital Recovery and AW
Capital recovery (CR) is the equivalent annual
amount that an asset, process, or system must earn
each year to just recover the first cost and a stated
rate of return over its expected life. Salvage value is
considered when calculating CR.
CR = -P(A/P,i%,n) + S(A/F,i%,n)
Use previous example:(note: AOC not included in CR )
CR = -20,000(A/P,10%,3) + 5000(A/F,10%,3) = $ –
6532 per year

Now AW = CR + A
AW = – 6532 – 8000 = $ – 14,532
Selection Guidelines for AW Analysis
ME Alternative Evaluation by AW
Not necessary to use LCM for different life alternatives

A company is considering two machines. Machine X has a first cost of


$30,000, AOC of $18,000, and S of $7000 after 4 years.
Machine Y will cost $50,000 with an AOC of $16,000 and S 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
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
AWD = Pi + AOC = -250,000(0.10) – 9,000
= $-34,000 Select alternative C
Typical Life-Cycle Cost Distribution by
Phase
Life-Cycle Cost Analysis
LCC analysis includes all costs for entire life span,
from concept to disposal

Best when large percentage of costs are M&O

Includes phases of acquisition, operation, & phaseout

 Apply the AW method for LCC analysis of 1 or more


cost alternatives
 Use PW analysis if there are revenues and other
benefits considered
Summary of Important
Points
AW method converts all cash flows to annual value at MARR

Alternatives can be mutually exclusive, independent,


revenue, or cost

AW comparison is only one life cycle of each alternative

For infinite life alternatives, annualize initial cost as A = P(i)

Life-cycle cost analysis includes all costs over


a project’s life span

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