Question

8. The company above is using expected expenses each year. In each year, there is a 5% probability of a worker injury and if that occurs, the expense for that year is $100. The company above purchases full insurance to cover the losses from worker injury for $1.25/year per share. a. What is the implied expense each year without insurance if no worker injury occurs? b. What is the implied insurance benefit each year if an injury occurs? C. What is the expected cash flow each year? d. Calculate the stock price, reflecting that full insurance was purchased, assuming the CAPM framework e. If, instead of CAPM, the market risk premiums for the company change due to the presence of full insurance such that the one-year, two-year (annualized) and three-year (annualized) risk premiums are 3.0%, 3.5% and 4.0%, what is the stock price? Compare the stock prices from question #7, #8d and #8e. What does this tell us about the potential value of insurance to a company? Should the company purchase the insurance?

Answer 1

Given if any injury occurs to a worker, expense for that year is $100 and the probability of occurance is 5%. total expense for 100% probability is $100/5%=$2000

a) implied expense without insurance and no injury is $2000-$500=$1500 if there is an injury then implied expense is $2000

b) implied insurance benefit is the amount saved on account of injury if insurance is taken i.e. $500-($1.25*No of shares).

c) expected cash flow if insurance taken is ($1.25*No of shares) if no insurance taken then it is $500

d) e) & f) Needs additional information to compute