Question

In: Finance

Ambrose Motor Corp. has expected cash flow for the next year equal to $ 1 million...

Ambrose Motor Corp. has expected cash flow for the next year equal to $ 1 million if it does not lose a product liability lawsuit and $0 if it loses the lawsuit. The CEO would work for $100,000 if he were certain to receive his promised compensation. However, if there is uncertainty for his compensation, he will work for the company only if the company pays him $125,000. The probability of the lawsuit is 90%. Now suppose that Ambrose Motor purchases $400,000 of liability insurance coverage at a premium of $30,000.

What is the expected claim cost?

What is the premium loading?

What is his expected compensation?

Fill out the shaded cells in the tables below

*No insurance*
Outcome	Probability	Cash flow before managerial compensation	Managerial compensation	Net cash flow to stockholders
No Lawsuit	0.90
Lawsuit	0.10
Expected cash flow

*Insurance*
Outcome	Probability	Cash flow before managerial compensation	Managerial compensation	Net cash flow to stockholders
No Lawsuit	0.90
Lawsuit	0.10
Expected cash flow

Expert Solution

Expected Cash flow if no lawsuit - $1000000

Expected Cash flow if lawsuit - $0

Prob of no Lawsuit - 0.90

Prob of Lawsuit - 0.10

Mangerial compensation if cetainity = $100000

Mangerial compensation if no cetainity = $125000

Premium for liability insurance coverage - $30000

Expected claim cost =

Premium Loading = $30000

What is his expected compensation ?
Remuneration	Prob	Expected payoff
125000	0.1	12500
100000	0.9	90000
		102500

*No insurance*
Outcome	Probability	Cash flow before managerial compensation	Managerial compensation	Net cash flow to stockholders
No Lawsuit	0.9	$ 10,00,000.00	$ 1,00,000.00	$ 8,00,000
Lawsuit	0.1	$ -	$ 1,25,000.00	$ -1,25,000
Expected cash flow				$ 6,75,000

*Insurance*
Outcome	Probability	Cash flow before managerial compensation	Managerial compensation	Net cash flow to stockholders
No Lawsuit	0.9	$ 10,00,000.00	$ 1,00,000.00	$ 8,00,000
Lawsuit	0.1	$ -	$ 1,25,000.00	$ -1,25,000
Claim	0.1			$ 40,000
Less Insurance Cost				$ -30,000
Expected cash flow				$ 6,85,000

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