Question

Your firm faces an 8% chance of a potential loss of $50 million next year. If your firm implements new safety policies, it can reduce the chance of this loss to 3%, but the new safety policies have an upfront cost of $250,000. Suppose that the beta of the loss is 0 and the risk-free rate of interest is 5%. If your firm is uninsured, the NPV of implementing the new safety policies is closest to: •

A. -$.25 million. • B. $2.25 million. • C. $2.5 million. • D. $2.15 million.

Answer 1

Our firm faces an 8% chance of a potential loss of $50 million next year

So the expected loss of our firm = 0.08 * 50 = $ 4 mil

Now if our firm implements new safety policies, it can reduce the chance of this loss to 3%

so the expected loss of our firm with new safety policies = 0.03 * 50 = $ 1.5 mil

The reduction in loss if we implement new safety policy = 4 - 1.5 = $ 2.5 mil

The present value of the Reduction in loss from next year with new safety policy = 2.5 / (1 + risk free rate)

= 2.5 / 1.05

= $ 2.381 mil

The NPV of implementing the new safety policies = 2.381 - initial cost

= 2.381 - 0.25 = $ 2.131 mil

So the value is closest to $2.15 mil option (D)