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A firm has an investment project that will cost the firm $30 million but will generate...

A firm has an investment project that will cost the firm $30 million but will generate $2 million of NPV. Also there is a 5% chance that the firm will lose a lawsuit to employees, and be forced to pay damage of $30 million. Suppose that a liability insurance policy with a $30 million limit has a premium equal to $1.5 million.
a. Compute expected claim cost
b. Compute the amount of loading on the policy
c. Compute the expected cost of not pursuing this project
d. Should the firm purchase this insurance or not? Why or why not?

Solutions

Expert Solution

a,Expected claim cost=probability of claim*damage amount

=.05*$30million

=$1.5 Million

b,Amount of loading on the policy=Premium-(expected claim cost)

=$1.5 million-$1.5 million=0

c,Expected Cost of not pursuing project=NPV of project-insurance premium

=$2million-$1.5 million=$500,000

d.Cost of policy premium =$1.5 million and expected cost of damage=$1.5million

Both expected damage and cost of premium are equal,but purchase of policy is recommended because

1.Nothing is added in the policy premium for administrative expenses of the policy

2.Insurance covers risk,even if damage is occured more than expected.

jeff jeffy answered 2 years ago
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