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Reviewing Complex Flow

Perpetuity

If there is a mix of recurring and nonrecurring or one-time cash flows that


must be capitalized for perpetuity:
1.) finding the NPW of all the onetime, non-recurring cash flows (=
CCPart 1 )
2.) finding the Annual Equivalent of
one cycle of all the recurring
cash flows, and then computing P
(= CCPart 2) from the perpetuity
relationship A = P(i)
3.) summing (1.) and (2.) to find the
total capitalized cost:
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CCTotal = CCPart 1 + CCPart 2

Perpetuity Example
A new football stadium will replace the
current municipal stadium at an initial
cost of $250 million.
One year later, the old stadium will be
demolished at a net cost of $1.5 million.
Annual maintenance is expected to be
$900 000, and every 15 years the
skyboxes will be remodeled at a cost of
$500 000.
Find the capitalized cost if the discount
rate is 10%, compounded annually.
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Perpetuity Example

DIAGRAM:
0

15

30

n= yrs
$900 K

$1.5 M
$500 K

$500 K

$250 M
CC1 = $250 000 000 + $1 500 000 (P|F,10%,1) = $ 251 363 650
CC2 = $900 000 + $500 000 (A|F,10%,15) =

$ 9 157 500

0.10
CCT = CC1 + CC2 = $251 363 650 + $9 157 500 = $ 260 521 150

ReviewingNPW
Two approaches to handle
differing project lives:
Common Multiple Period:
Projects are assumed to be
repeated until a common
multiple point in time is
established.
Study Period: Select a study
period for both projects
and estimate cash flows to
conform to the study
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Equivalent
Annual Worth Analysis
Equivalent Annual Worth
(EAW) can be used to
compare projects.
Equivalent Annual Cost
(EAC) can be used instead
of EAW if revenues are not
included.
EAC = EAW

Equivalent Annual
Worth Analysis

EAW and Types of Projects:


Revenue projects are
expected to make money
at a rate at least as high
as the MARR, so select
largest EAW that is 0.
Service projects are have
to do situations, so
select largest EAW (lowest
EAC).
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Capital Cost Recovery


For a capital purchase (P)
with a salvage value (S),
the EAC can be calculated
two ways:
1.P(A/P, i, n) S (A/F, i, n)
2.(P S) (A/P, i, n) + S( i )
Annual equivalent
for loss of value

Opportunity
cost

Capital Cost Recovery


Land is considered to have
infinite life; it can be sold
for its purchase price
(neglecting inflation).
P = S and EAC = S*i

Example 1
The Ragweed Pollination Company needs a
new building to expand seed production.
The building will cost $600,000, last for 30
years, and is expected to sell for
$100,000. It will be built on property that
costs $200,000, which will be sold with the
building. Energy costs are projected to be
$45,000 the first year increasing by $3,000
each year after that. Needed equipment
will cost $70,000 and last 10 years with
no salvage value. It will be replaced with
identical equipment 10 and 20 years from
now. Annual maintenance is projected to
be $20,000. Determine the Equivalent
Annual Cost (EAC) for the proposed
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expansion using a MARR of 18%

1st Costs:

Annuals:

Increases:
Replacements:

Salvage:

Lifetime:
MARR:
FIND:

200 000

Land

600 000

Building

70 000

Equipment

20 000

Maintenance

45 000

Energy

3 000/yr Energy
70 000

Equipment (yr 10)

70 000

Equipment (yr 20)

100 000

Building (yr 30)

200 000

Land

30 yrs
18%,

cpd annually

EAC (= EAW)
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$200 K
EAC = ?

DIAGRAM:

10

20

$100 K
n=30 yrs
$20 K

$200 K
$600 K

$45 K
G=$3 K

$70 K
EAC = A0 + AN + AI + AR + AS

$70 K

= (200 000 + 600 000 + 70 000) (A|P,18%,30)

$70 K

+ (20 000 + 45 000)


+ 3 000 (A|G,18%,30)
+ [70 000 (P|F,18%,10) + 70 000 (P|F,18%,20)] (A|P,18%,30)
(100 000 + 200 000) (A|F,18%,30)
= 157 731 + 65 000 + 16 034 + 2 888 390 = $241 263 / yr

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Example 2
A 1000-foot tunnel must be constructed as part of
a new aqueduct system for a major city. Two
alternatives are being considered. One is to build
a full-capacity tunnel now for $400,000. The
other alternative is to build a half-capacity tunnel
now for $200,000, and then to build a second
parallel half-capacity tunnel 20 years hence for
$300,000. The cost of repair of the tunnel lining
at the end of every 10 years is estimated to be
$20,000 for the full capacity tunnel and $18,000
for each half-capacity tunnel.

Determine whether the full capacity tunnel or the


half-capacity tunnel should be constructed now.
Solve the problem by annual worth analysis,
using an interest rate of 6% per year compounded
annually, and a 50-year analysis period. (Note:
There will be no tunnel lining repair at the end of
the 50 years.)
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DIAGRAM: Full Tunnel


10
0
$20 K

20

30

40

$20 K

$20 K

$20 K

n=50 yrs

$400 K
EAWF = (A|P,6%,50)[ 400 000 20 000(P|F,6%,10) 20 000(P|F,6%,20)
20 000(P|F,6%,30) 20 000(P|F,6%,40)]
= $26 807 / yr
DIAGRAM: Half Tunnel
10
0
$200 K

$18 K

20
$18 K

30
$18 K
$18 K

40

n=50 yrs

$18 K
$18 K

$300 K
EAWH = (A|P,6%,50)[ 200 000 18 000(P|F,6%,10) (300 000 +18 000)(P|F,6%,20)
(18 000 +18 000)(P|F,6%,30) (18 000 +18 000)(P|F,6%,40)]
= $20 223 / yr

CHOOSE THE HALF TUNNEL OPTION


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Example 3
Your in-laws paid cash for a home they
purchased 18 years ago for $100,000. They
just sold it for $100,000. They were bragging
that, neglecting such expenses as taxes,
insurance, and utilities, it did not cost them
anything to live in the house for the 18 years.
Having just completed an engineering
economics course as a part of your
engineering degree, you knew immediately
that your in-laws reasoning was incorrect.
Identify and describe the engineering
economic principle involved.
Include in your explanation what it
actually cost your in-laws each year to
own the house provided that they value
money at 6% per year compounded
annually. (Do not include changes in the
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purchasing power of money, and continue

What is the Engr Econ


principle of Example 3?
The economic principle is OPPORTUNITY COST:

EAC = (P S)(A|P,i,N) + S(i)


= ($100 000 $100 000)(A|P,6%,18) + $100 000(6%)
= $0 + $6 000
= $6 000 / year to live in the house for each of the past 18 years.

Effectively, you could tell your in-laws that if they had truly lived in the house
for free, they could have spent $6 000 per year on better raising your spouse
but then, again, maybe you shouldnt.
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