A risk manager is considering the use of an innovative ventilation method in an area in which employees use potentially toxic solvents. The toxic solvents will be used for a five year period. The ventilation method costs $150,000 to implement. The new method will increase annual maintenance costs for the area by $5000 but is expected to
reduce the employer’s retained work-injury losses by $35,000. In addition, the insurer that writes the employer’s workers compensation insurance is willing to reduce the insurance premium by $45,000 per year if the method is used. The employer faces a 30 percent income tax rate and has an annual discount rate of 5 percent.
Assume that maintenance and retained work-injury losses are realized at the end of the year, that insurance premiums are paid at the beginning of the year, and that income taxes are paid at the end of the year. Assume that the cost of implementing the ventilation system is realized at the beginning of the first year, and that 1/5 of the total costs of the system can be deducted from taxable income (as depreciation) in each of the five years (not 100% in the first year).
a. Calculate the annual net savings from the ventilation system.
b. Calculate the present value of the after-tax net annual savings from the ventilation system over the five years of its operation.
c. Calculate the present value of the after-tax purchase cost of the ventilation system.
d. Do your calculations suggest that the ventilation system should be introduced? Demonstrate and explain.
e. Does changing the firm’s income tax rate to 15% affect your recommendation Demonstrate and explain. (note: if you do the problem using Excel this sensitivity check should be easy to calculate).
f. Ignoring the changes you made in part e, does changing the firm’s annual discount rate to 10% affect your recommendation? Demonstrate and explain. (note: if you do the problem using Excel this sensitivity check should be easy to calculate).
g. What other considerations should the risk manager include in his calculations and/or report to management about this decision?