Consider a firm that has a 5% chance of a loss of ten million dollars. If there is no loss, the firm will make five million dollars. Therefore, in the loss state, the firm will have a net loss of $5 million ($5m-$10m=-$5m). If the firm is taxed 34% on all earnings above zero dollars, show that they will be willing to pay $600,000 for insurance (with full indemnity) even though the expected loss is only $500,000. What is the most the firm would be willing to pay for insurance?

Essentials Of Investments
11th Edition
ISBN:9781260013924
Author:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Publisher:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Chapter1: Investments: Background And Issues
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Consider a firm that has a 5% chance of a loss of ten million dollars. If there is no loss, the firm will make five million dollars. Therefore, in the loss state, the firm will have a net loss of $5 million ($5m-$10m=-$5m). If the firm is taxed 34% on all earnings above zero dollars, show that they will be willing to pay $600,000 for insurance (with full indemnity) even though the expected loss is only $500,000. What is the most the firm would be willing to pay for insurance?

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