As the text states, the annual equivalent (AE) worth criterion is a "basis for measuring investment worth by determining equal payments on an annual basis."  The equation for computing AE for a project is shown in Equation 8.1.    The criterion for deciding on a proposed project is based on the computed AE.    The decision rule for accepting or rejecting projects according to the AE criterion is exactly the same as the one for the present worth case.  Given this, it is reasonable to ask why AE is needed at all.  If the PW and AE criteria lead to the same conclusion, why are two methods needed when one is sufficient for the task?

Benefits of AE Analysis

There are some instances when AE is more appropriate than PW analysis.  Examples are the following.  Financial reporting is usually done for annual periods; annual equivalent analysis is thus required.  In other cases unit profits and costs are required for annual periods for comparison between or among alternatives.  And when comparing alternative projects with unequal lives, AE analysis methods simplify the analysis.

Capital versus Operating Costs

Project costs can be of three types:  an initial cost to set up the project, the recurring cost to run the project, and cost for or return from salvage.  Usually, the initial cost is the capital cost and the recurring cost is the operating cost.  There can be a different kind of recurring cost: when the analysis period is longer than the project life, replacement of the equipment will be required at the end of the project life.  The replacement cost can also be viewed as a recurring cost, recurring periodically for the duration of the analysis period.  But replacement cost is not operating cost.

Capital cost usually occurs at one time period, usually at time zero, which is the start of the project.  If the project has a salvage value, it will also be a one time cost, occurring at the end of the project.  In AE analysis, both of these types of one-time costs need to be converted into annual equivalent  costs.  Equations 8.2 and 8.3 show how that can be done.  The text provides an intuitive interpretation of Equation 8.3.