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1. A firm has an investment project that will cost the firm $35 million but will...

1. A firm has an investment project that will cost the firm $35 million but will generate $2.5 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 $35 million. Suppose that a liability insurance policy with a $35 million limit has a premium equal to $2 million. Compute expected claim cost Compute the amount of loading on the policy Compute the expected cost of not pursuing this project Should the firm purchase this insurance or not? Why or why not?

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Answer #1

Expected Claim Cost = Expected lawsuit claim * Probability of occurence of event

= $35 million * 0.05

= $1.75 million

Cost of insurance = $2 million

Loading on policy = $0.25 million

Yes, the firm should purchase the insurance if it pursues the project. This is because the company will go into bankruptcy in case the lawsuit is attracted. Also the cash generation is 2.5 million which means that the insurance payment will not dig into capital and can be re-payed from the cash flow generated itself.

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