Evaluating Business and

Engineering Assets II
The Annual Worth Method and
the Rate-of-Return
Annual Worth Method
• basis of determining investment worth by
determining payments on an annual basis

▫ AW(i) = PW(i) (A/P, i, N) = FW(i) (A/P, i, N)

• The accept/reject decision rule

▫ AW(i) >0 ; accept the investment
▫ AW(i) =0 ; remain indifferent
▫ AW(i) <0 ; reject the investment
Note
• The annual worth must be calculated for only
one life cycle

• Can sometimes be broken down into two

components, capital recovery (CR) for the initial
investment P and the equal annual amount A
Example 1
• Lockheed Martin is increasing its booster thrust power to win
more satellite launch contracts from European companies
interested in opening up new global communications markets.

• A piece of earth-based tracking equipment is expected to

require an investment of $13M, with $8M committed now and
the remaining $5M expended at the end of year 1 of the
project. Annual operating costs for the system are expected to
start the first year and continue at $0.9M per year.

• The useful life of the tracker is 8 years with a salvage value of

$0.5M. Calculate the AW value for the system, if the current
MARR is currently 12% per year.

▫ AW = $-3.37M per year

Benefits of Annual Equivalent Worth
Analysis

• Consistency of report formats

• Need for unit costs/profits

• Unequal project lives

Example 2
• PizzaRush, which is located in the general LA area, fares very
well with its competition in offering fast delivery. The owner,
a software engineering graduate of USC, plans to purchase
and install 5 portable, in-car systems to increase delivery
speed and accuracy.

• Each system costs $4,600, has a 5 year useful life, and may be
salvaged for an estimated $300. Total operating costs for all
systems is $650 for the first year, increasing by $50 per year
thereafter. The MARR is 10%. Perform an AW evaluation for
the owner that answers the following questions:
▫ How much new annual income is necessary to recover the
investment at the MARR? ($5,822)
▫ The owner conservatively estimates increased income of $1,200
per year for all 5 systems. Is this project financially viable at the
MARR? (-$5,362)
Applying Annual Worth Analysis
• Unit/Profit Cost Calculation
▫ determine the no. of units to be produced
(serviced) each year
▫ identify the cash flow series associated with
production or service
▫ calculate the net present worth of the project cash
flow series at a given interest rate then determine
the equivalent annual worth
▫ divide the EAW by the number of units to be
produced (serviced) per year
Example 3
• Tiger Machine Tool Company is considering the
proposed acquisition of a new metal cutting
machine. The required initial investment of
75,000php and the projected cash benefits over
the project’s 3-year life are as follows:
End of Year Cash Flow
0 -75,000
1 24,000
2 27,340
3 55,760

• If MARR is 15%, Find NPW

▫ 3,205.65php
Cont…
Example 3
• Suppose that the machine will be operated for
2,000hours per year. Compute the equivalent
savings per machine hour at an i = 15%?

▫ AW(15%)=1,403.98php
▫ 0.70php/hour
Applying Annual Worth Analysis
• Make-or-Buy Decision
▫ determine the time span (planning horizon) for which
the part (product) will be needed
▫ determine the annual quantity of the part
▫ obtain the unit cost of obtaining the part from an
outside firm
▫ determine other factors required to make the part
▫ estimate net cash flows associated with the ‘make’
option
▫ compute the annual equivalent cost of production
▫ compute the unit cost of making the part
▫ choose option with MINIMUM cost
Example 4
• The operations manager of a fast-food
hamburger chain is planning to add salads to the
menu. There are two ways of doing this, both
resulting in the same price of salad for the
customer. The make option involves the
installation of a salad bar stocked with
vegetables, dressings, and others. The annual
leasing cost (including maintenance) of the salad
bar is $120,000. Aside from that, a part-time
employee needs to be hired, pushing the unit
variable cost to $15.
Continuation...
• The buy option is to have pre-assembled salads
that cost $20 per salad. Additional refrigeration
is needed and this will cost $24,000 (including
maintenance and operation). What quantity of
salads sold in a year would make us indifferent
to either option? Which option would you
choose if you predict you can sell 25,000 salads
a year?
Applying Annual Worth Analysis
• Break-Even Point
▫ is the quantity of production at which the curve for
total income intersects the curve for total costs
Example 5
• A telephone switchboard cable can be made up of
either enameled wire or tinned wire; there are 400
soldered connections. The cost of soldering a
connection on the enameled wire will be 16.50php;
on the tinned wire it will be 11.50php. A cable made
up with enameled wire costs 56php per lineal meter
and one made up with tinned wire 85php per lineal
meter. Calculate the length of the cable used so that
the cost of each installation will be the same.

▫ 69 meters
Rate-of-Return
• the interest rate earned on the unpaid balance of
an amortized loan

• Example 1: Suppose that a bank lends $10,000

and it is repaid $4,021 @ the end of each year
for 3 years. How would you determine the
interest rate that the bank charges on this
transaction?
Solving for i

 (1 + i ) − 1
3
10,000 = 4,021 3 
 i (1 + i ) 
• i =10%
Rate of Return
• is the break-even interest rate (i*) which equates
the present worth of a project’s cash outflows to
the present worth of its cash inflows

• i* of a project is the rate of interest that equates

the present worth, future worth and annual
equivalent worth of the entire series of cash
flows to zero.
Return on Invested Capital
• a project’s return is referred to as the internal
rate of return or the yield promised by an
investment project over its useful life

• “Internal rate of return” is the interest rate

charged on the unrecovered project balance of
the investment, such that when the project
terminates, the unrecovered balance will be zero
Example 2
• Suppose a company invests $10,000 in a
computer with a 3-year useful life and equivalent
annual labor savings of $4,021.
n Beginning Return on Ending Project
Project Balance Invested Cash Balance
Capital Payment
0 0 0 -10,000 -10,000

1 -10,000 -1,000 4,021 -6,979

2 -6,979 -697 4,021 -3,656

3 -3,656 -365 4,021 0

IRR Criterion
• as we compute for the project’s PW @ varying
interest rates, we see that
▫ NPW is positive for i<i*
▫ NPW is negative for i>i*

• IRR > MARR, acceptable

• IRR = MARR, indifferent
• IRR < MARR, reject
Example 3
• A capital investment of 10,000PhP can be made
in a project that will produce a uniform annual
revenue of 5,310PhP for 5 years and then have a
salvage value of 2,000PhP. Annual expenses will
be 3,000PhP. The company is willing to accept
any project that will earn at least 10% per year
on all invested capital. Determine whether it is
acceptable using the IRR method.
Note
• When applied correctly, the ROR technique will
always result in a good decision.
 “Engineering is not merely knowing and
being knowledgeable, like a walking
encyclopaedia; engineering is not merely analysis;
engineering is not merely the possession of the
capacity to get elegant solutions to non-existent
engineering problems; engineering is practicing the
art of the organized forcing of technological
change... Engineers operate at the interface
between science and society...”

-Dean Gordon Brown