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Liability insurance and expected after tax earnings

Suppose that the Lai Jean Co. expects before tax earnings of 5 million this coming year, assuming no liability losses. However, there is a 2 percent chance that Lai will lose a $10 million lawsuit during the year. Profits are taxed at a rate of 34 percent. Assume that Lai cannot carry losses forward or backward (e.g., it has had no profits in the past and it expects to close down next year). Would liability insurance with a $10 million limit for a premium of $225,000 increase expected after-tax earnings for this coming year? (Assume the negative earnings are taxed at a rate of zero percent).

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If the company loses the lawsuit, the liability insurance policy will definitely help in increasing the after tax earnings because it will not only prevent the company from bearing the liability of $10m arising due to the lawsuit, but the insurance ...

Solution Summary

Suppose that the Lai Jean Co. expects before tax earnings of 5 million this coming year, assuming no liability losses. However, there is a 2 percent chance that Lai will lose a $10 million lawsuit during the year. Profits are taxed at a rate of 34 percent. Assume that Lai cannot carry losses forward or backward (e.g., it has had no profits in the past and it expects to close down next year). Would liability insurance with a $10 million limit for a premium of $225,000 increase expected after-tax earnings for this coming year? (Assume the negative earnings are taxed at a rate of zero percent).

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