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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?

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Answer #1

a)Expected claim cost=30million*5%=1.5million(Total claim *Probability of event happening)

b)Amount of loading=Loading means fraction of premium that goes above actual cost which is 0 in this case as the premium and claim cost both are 1.5 million

c)Expected cost of not pursuing is 2 million which is the profit firm could have earned using the project

d)Firm should go for the project as net to net they can earn profit of 0.5 million any case.Firm earns a NPV of 2 million and if it doesnt buy insurance and claim is being made by emloyee total loss is 28 million(+2-30) and if they buy insurance then profit is 0.5(+2-1.5). If the claim is not reality then 2 million straight away. Considering that scenario firm should go with policy

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