Question

1. A firm spends $800,000 annually for electricity. Alternatively, the firm could install a new computer-controlled lighting system that will reduce electric bills by $90,000 in each of the next three years. Assume the interest rate is 4%. If the system costs $230,000 to be fully installed,

a. is this a good investment? Show your derivation.

b. What if the interest rate rises to 8%? Explain the intuition.

Answer 1

Without the system annual electricity expense = $800,000

With the lighting system, the annual expense of electricity are reduced by = -230000(A/P, 4%, 3) + 90000 = -230000*0.360349 + 90000 = $7120.

a. It is a good investment because annual expenses are reduced by 7120.

b. If the interest rate rises to 8%, the he annual expense of electricity are reduced by = -230000(A/P, 8%, 3) + 90000 = -230000*0.388034 + 90000 = $752.18. Again it is a good investment because it saves $752.18 in bills.