Benefit Wood Warehousing has property insurance on a replacement cost basis with a $5,000 per occurrence
deductible. It can install automatic sprinklers in its warehouse for an initial cost of $10,000. The sprinklers will last five years (they would last much longer in real life). Annual maintenance cost of the sprinklers will be $1,000, payable at the end of each of the first four years from the time of installation. If Wood installs the sprinklers, it will deduct one-fifth of the installation price at the end of each year for five years as depreciation (a non cash expense) for tax purposes (i.e., the sprinklers will be fully depreciated over five years). Without the sprinklers, the firm believes that its expected cash outflow for losses less than the deductible will be $1,000 per year and that its insurance premium will be $10,000 per year. With the sprinklers, it believes that its expected cash outflow for losses less than the deductible will be $500 per year and that its insurance premium will be $7,000 per year. Wood's opportunity cost of capital for this decision is 10 percent. Retained losses are paid and deductible for tax purposes at the end of each year. Insurance premiums are paid at the beginning of the year and are deductible for tax purposes when paid. The tax rate is 34 percent.
a. Should Wood install the sprinkers? Support your answer by calculating the net present value of installing the sprinklers. Show your work.
b. Briefly explain the sources of uncertainty in this decision, i.e., what other factors might cause you to change your decision?