ENME619.

12 Fundamentals of Pipeline Economics

TOPIC 4 ANNUAL WORTH AND BENEFIT/COST RATIO COMPARISONS

Textbook:
• Riggs, J.L., Bedworth, D.D., Randhawa, S.U., and Khan, A.M., Engineering
Economics, 2nd Canadian Edition, McGraw Hill, 1997, Chapters 4, 8.
Supplementary Readings:
• Blank, L., and Tarquin, A., Engineering Economy, 6th Edition, McGraw Hill, 2005,
Chapters 6, 9.
• Park, C.S., Pelot, R., Porteous, K.C., and Zuo, M.J., Contemporary Engineering
Economics, 2nd Canadian Edition, Addison Wesley Longman, 2001, Chapters 4, 5.
• Steiner, H.M., Engineering Economic Principles, 2nd Edition, McGraw Hill, 1996,
Chapters 6,7.

4.1 Annual worth comparisons

a. What is the annual worth comparison?
It is the method to compare the alternatives by their annual gain in the case of a
positive annual worth or annual loss in the case of a negative annual worth. It is a
much more understandable method to ordinary people.
Annual worth (AW): encompasses both gain and loss.
Equivalent uniform annual benefit (EUAB): BA
Equivalent uniform annual cost (EUAC): CA
The capital recovery factor (A/P,i,N) is the cornerstone for this method.
If AW= BA - CA 0, an alternative is acceptable.
Case 1: You are considering an investment in a laundromat. The washers and dryers will
cost $5,000 and will last for 3 years with no resale value at the end of that time.
Rent, labour, and maintenance will approximate $11,000 annually. Total revenue is
estimated as $20,000 per year. The time horizon of the operation is 3 years. Your
opportunity cost of capital for a similar-risk investment is 20 percent before taxes.
For the moment, you ignore inflationary effects on your decision. Should you invest
in the laundromat?
Solution:
BA =$20,000
CA =$11,000+$5,000(A/P,20%,3)=$11,000+$5,000*0.47473
=$13,373.65
AW= BA - CA =$20,000-$13,374=$6,626.35
It is worth for you to invest in the laundromat.

b. Annual-cost Analysis
When only costs are present for all the alternatives, you have to use annual-cost
analysis to make decision. The way is to convert the principles (or costs) into
annuities by (A/P,i,N).

c. Salvage Value
The salvage or resale value (S) is the amount an asset can be sold for when its
economic life is over for the enterprise owning it.

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Annual cost = P(A/P, i, N)-S(A/F, i, N) or

Annual cost = (P-S)(A/P, i , N)+Si

d. Unequal Lives: The annual worth comparison method can ignore the problem of
alternatives with different lives.

Case 2: Two types of dump trucks for small jobs are being considered by a paving
contractor in Mexico. Data are as follows:
Mercedes- Ford
Benz
Cost 150,000 100,000
Annual maintenance (pesos) 10,000 12,000
Economic life (years) 10 5
Resale value (pesos) 15,000 10,000
The opportunity cost of capital for this contractor is 25 percent. Which maker should
be chosen?
Solution:
Ford
ACF=(100,000-10,000)(A/P,25%,5)+10,000*25%+12,000
=90,000*0.37185+10,000*0.25+12,000=47,966.50 (pesos)
Mercedes-Benz
ACMB=(150,000-15,000)(A/P,25%,10)+15,000*25%+10,000
=135,000*0.28007+15,000*0.25+10,000=51,559.45 (pesos)
The Ford is cheaper than Mercedes-Benz. Therefore, we chose Ford.

e. Perpetual lives in annual worth

A=Pi

4.2 Benefit/cost ratio comparisons

a. Basic Condition
B
1
C
By using B/C ratio comparison method, the incremental analysis is necessary.
Otherwise, you may give a wrong solution.

Case 3: A state highway department is attempting to choose between two highway noise
barriers. Because the highway contract calls for some sort of barrier, a wood or
metal barrier will be selected. Net costs and benefits per mile for a life of 20 years
are as follows:
Metal Wood
First cost ($) 152,200 183,800
Maintenance cost per year ($) 2,000 3,000
Benefits per year ($) 24,100 28,900
Because this is a public project, no taxes will be paid. Inflation effects will be
practically equal between the alternatives. A 10 percent minimum attractive rate of

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return (MARR) will be used for the analysis.

Solution:
Incremental analysis (Wood – Metal):
(Benefit)=(28,900-3,000)-(24,100-2,000)=$3,800
(Cost)=183,800-152,200=$31,600
B 3800( P / A,10%,20) 3800 * 8.5136
   1.02  1
C 31,600 31,600
Decision: To select Wood noise barrier.

Individual analysis:
B 22,100( P / A,10%,20)
Metal:   1.24
C 152,200
B 25,900( P / A,10%,20)
Wood:   1.20
C 183,800
Decision: Since 1.24>1.20, to select Metal noise barrier.

Approved by the present worth comparisons

Metal: PVm=-152,200+22,100(P/A,10%,20)=$35,950.56
Wood: PVw=-183,800+25,900(P/A,10%,20)=$36,702.24
NPVw-m=-31,600+3,800(P/A,10%,20)=$751.68
Decision: To select Wood noise barrier.

b. Formulas
Step 1: Net out the cash flow. In the cash flow diagram, the up arrows minus the
down arrows.
Step 2: Apply the following equations:
N
 Bj( P / F , i, j )
B j  0 B A( P / A, i, N )
 or  Co=initial cost.
C N C C0
 Cj( P / F , i, j )
j 0
Case 4: A real estate developer is facing the following two alternatives:
1) Multistory parking garage (alternative 1), 80 million pesos (investment), 31
million pesos per year (revenues), 12 million pesos per year (cost), 20 years
time horizon, 100% salvage value in the end of 20 years.
2) Office building (alternative 2), 130 million pesos (investment), 38 million
pesos per year (revenues), 13 million pesos per year (cost), 20 years time
horizon, 100% salvage value in the end of 20 years
Solution:
 B  19( P / A,10%,20)  80( P / F ,10%,20)
 C    2.2  1
  10 80
 B  6( P / A,10%,20)  50( P / F ,10%,20)
 C    1.17  1
  21 50

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Alternative 2 is better than alternative 1.

Possible wrong solution:

 B  25( P / A,10%,20)  130( P / F ,10%,20)
 C    1.8  2.2
  20 130
Alternative 1 is better than alternative 2.

c. Costs versus disbenefits

In the B/C ratio calculations, an annual cost of an alternative may be subtracted from
its annual benefits (i.e. as a disbenefit) and then discounted to its total present benefit
(i.e. B in the B/C equation). It also can be discounted to a cost at its present worth
and then added into the total cost (i.e. C in the B/C equation). To treat an annual cost
as a disbenifit or as a cost will result in different values of a B/C ratio, but will not
affect the final justification on the alternatives.
Case 5: Two plans for a funicular railway have been proposed in the following table. The
opportunity cost of resources is 10 percent applied to constant money units. All costs
and benefits are in constant millions of dollars.
Plan 1 Plan 2
Economic life (years) 20 40
Salvage value 12 15
Annual benefits 22 25
Annual operation and maintenance cost 3 5
Initial cost 160 300
Use the benefit/cost ratio method to choose one of the two proposals.
Solution:
1) Treat the annual operation and maintenance cost as a cost (ie. part of the
denominator in the B/C ratio)
B( Plan1  Null ) (22)( P / A,10%,20)  12( P / F ,10%,20)
( B / C ) P10  
C ( Plan1  Null ) 160  3( P / A,10%,20)
22 * 8.5136  12 * 0.1486
  1.019  1
160  3 * 8.5136
Decision: Plan 1 is better than null (i.e. doing nothing).

2) Treat the annual operation and maintenance cost as a dis-benefit (ie. part of
the numerator)
B( Plan1  Null ) (22  3)( P / A,10%,20)  12( P / F ,10%,20)
( B / C ) P10  
C ( Plan1  Null ) 160
 1.022  1
Decision: Plan 1 is better than null (i.e. doing nothing).

Incremental analysis between P1 and P2

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 B  1( P / A,10%,40)  148( P / F ,10%,20)  3( P / F ,10%,40)

 C  
  P 2 P1 140
1 * 9.7791  148 * 0.1486  3 * 0.0221
  0.227  1
140
Plan 2 is not justified.

4.3 Applications

Case 6: A piece of pipeline equipment was purchased 5 years ago for $52,000. It was
expected to have an economic life of 8 years, at which time its salvage value would
be $4000. If the function that the equipment was serving is no longer needed, for
what price must it be sold now to recover the invested capital when i=12 percent?
Solution:
The annual cost of the equipment over its 8-year life:
AC=(P-S)(A/P,12%,8)+S*12%=(52000-4000)*0.2013+4000*0.12=$10,142.40

Uncovered capital at the end of year 5:

Selling price=10,142.40(P/A,12%,3)=10142.40*2.4018=$24,360.02

Case 7: Two mutually exclusive alternatives have the following case flow patterns:

Year Alternative 1 Alternative 2

0 -100 -100
1 75 80
2 50 40
3 25 20
MARR=12%. Use B/C ratio to determine which alternative should be chosen. The
default null alternative (i.e. do nothing) must be considered.
Solution:
(B/C)2= [80(P/F,12%,1)+40(P/F,12%,2)+20(P/F,12,3)]/100
=(80*0.8929+40*0.7972+20*0.7118)/100=1.176>1
(ΔB/ΔC)1-2=[10(P/F,12%,2)+5(P/F,12%,3)]/[5(P/F,12%,1)]
=(10*0.7972+5*0.7118)/(5*0.8929)=2.583>1
Therefore alternative 1 should be selected.

4.4 Tutorial questions

a. Problem 1
A car buyer paid $5,642.37 cash for a used Datsun. He wishes to know what the
ownership of the car will cost him annually based on an estimated life of 5 years and
$1,000 resale value, if his estimated opportunity cost of capital averages 15 percent
during the next 5 years. Disregard inflationary effects. The car ownership offers no
tax advantages.

b. Problem 2
A vacation home in the mountains may be bought for $80,000 in cash. Mortgage

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financing is available at 12 percent for 30 years with a 10 percent down payment.

The upkeep and taxes will cost about $1,000 per year. The prospective buyer is an
investor who regularly makes 20 percent on an investment of equal risk.
Disredarding inflationary effects and possible property appreciation, how much will
the property cost her each year if she holds it for 30 years? Ignore possible tax
advantages, and assume that the property will have a resale value equal to its original
cost.

c. Problem 3
A city engineer in a small town in Nevada is considering curb installation on certain
streets off Main Street. She has before her two alternatives, one of which she is
certain to choose:
Granite Concrete
First cost ($) 125,000 85,000
Life (years) Infinite 25
Annual maintenance cost 1,000 5,000
The granite curbing, with proper maintenance, will last indefinitely. No salvage
value is expected for either curbing.
A 10 percent discount rate is to be used.
City ordinances do not specify any particular method of economic analysis for his
situation. The engineer will therefore use the most convenient correct method.
Which curbing should she choose?

d. Problem 4
A multiple-purpose dam, to be built over 4 years, is being considered for
construction. Its first cost, distributed evenly over 4 years, is $80 million. Its
benefits, beginning during the first year after construction is completed, over a life of
100 years, are $6 million per year. Its annual operations cost, beginning at the same
time as the benefits, is $900,000. The minimum attractive rate is 5 percent, and the
salvage value is zero. Calculate its benefit/cost ratio.

e. Problem 5
A proposed investment shows the following benefits and costs:
Year Cost Benefit
0 80 0
1 160 0
2 10 100
3 20 120
4 20 130
5 30 80
6 40 70
If the minimum attractive rate of return (MARR) is 12 percent and taxes and
inflation are ignored, what is the benefit/cost ratio of this investment if netting out
(that is, the rule of delta) is used? Is the project acceptable?

f. Problem 6

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In a large electric generating plant, two designs for coal car thawing sheds are being
considered to replace an existing one. Each will cost the same amount $1,090,000.
The electrically heated shed will last 10 years; the gas-heated shed will last 15 years.
The salvage value will approximate the removal cost for both designs. The before-
tax cost of capital for this firm is 20 percent.
Maintenance and operation costs for the electric model will be $80,000 per year. The
same costs for the gas shed will be $100,000 per year. Which design should be
chosen if the benefit/cost ratio method is used?

Answers to tutorial questions

Problem 1 $1,535 per year.
Problem 2 Annual mortgage cost=72,000(A/P,12,30)=$8938. about $11,500 per year.
Problem 3 ACG=$13,500, ACC=$14,364, choose Granite.
Problem 4 1) B/C=101.2/86.2=1.17; 2) B/C=119.1/(86.2+17.9)=1.14.
Problem 5 B/C=256/223=1.148.
Problem 6 B / C(Gas  electric )  200.7 / 166.5  1.2 .

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