Eddie\'s Precision machine shop is insured for $700,000. The present yearly insu

Question

Eddie's Precision machine shop is insured for $700,000. The present yearly insurance premium is $1.00 per $100 of coverage. A sprinkler system with an estimated life of 20 years and no salvage value can be installed for $20,000. Annual maintenance costs for the sprinkler system are $400. if the sprinkler system is installed, the system must be included in the shop's value for insurance purposes, but the insurance premium will reduce to $0.40 per $100 of coverage. Eddie uses a MARR of 15 percent/year.
a. what is the present worth of this investment?
b. what is the decision rule for judging the attractiveness of investment based on present worth?
c. is the sprinkler system economically justified?

Explanation / Answer

Without the investment:

Insurance value = $700,000

Annual insurance premium = $700,000 x 1 / 100 = $7,000

With the investment:

Incremental Insurance value = $20,000

Incremental savings on Annual insurance premium = $7,000 - [$720,000 x 0.40 / 100] = $4,120

Annual maintenance cost = $400

Incremental Annual net savings (benefits) = $4,120 - $400 = $3,720

So:

(a) Present worth of this investment = Sum of present value of all cash flows

= - $20,000 + $3,780 x Present value interest factor of annuity, PVIFA (15%, 20 years)

= - $20,000 + $3780 x 6.2593 (From PVIFA table)

= $3,660

(b) The decision rule is that if present worth is positive, the project should be accepted.

(c) Here the investment is economically justified since its present worth is positive.

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