Ambrose Motor Corporation has expected earnings before interest payments for the next year equal to $100 million if it does not lose a product liability lawsuit. Interest and principal payments on its debt equal $60 million, leaving $40 million for shareholders if it does not lose a product liability suit. The probability of losing a product liability suit is 0.02, and the expected damage if a suit is lost equals $50 million. If the suit is lost, the firm will be unable to make its promised payments to debt holders and it will have to renegotiate its debt payments. The legal and administrative costs of negotiations equal $5 million. Should Ambrose Motor purchase a liability insurance polity with a $50 million limit for a premium of $1.2 million? Explain.
Probability of loss = 0.02
Amount at loss = Damage under law suit + admin cost of renegotiating debt payment
=$50 million + $5 million = $55 million
Expected value of loss = $55 ...
This post discusses about the purchase of liability insurance policy without lose a product liability lawsuit