Chapter 13, Problem 27BEB

1.

To determine

Compute inherent risk.

Answer to Problem 27BEB

Inherent risk is $400,000.

Explanation of Solution

Inherent Risk:

Inherent risk is a risk that prevails in a system before any control measure is adopted within an organization.

Computation of inherent risk:

Inherent risk can be computed by using the following formula:

$\text{Inherent}\text{risk}=\text{Impact}\times \text{Probability}\text{of}\text{occurrance}$

Substitute $1,000,000 for impact and 40% for the probability of occurrence in the above formula.

$\begin{array}{c}\text{Inherent}\text{risk}=\$1,000,000\times 40\%\\ =\$400,000\end{array}$

Therefore, inherent risk is $400,000.

2.

To determine

Compute residual risk of each of the three alternatives.

Answer to Problem 27BEB

Residual risk for alternative A, B, and C is $48,750, $105,000, and $400,000respectively.

Explanation of Solution

Residual risk can be computed by using the following formula:

$\text{Residual}\text{risk}=\text{Impact}\times \text{Probability}\text{of}\text{occurrance}$

Computation of residual risk for alternative A:

Substitute $325,000 for impact and 15% for the probability of occurrence in the above formula.

$\begin{array}{c}\text{Residual}\text{risk}=\$325,000\times 15\%\\ =\$48,750\end{array}$

Computation of residual risk for alternative B:

Substitute $300,000 for impact and 35% for the probability of occurrence in the above formula.

$\begin{array}{c}\text{Residual}\text{risk}=\$300,000\times 35\%\\ =\$105,000\end{array}$

Computation of residual risk for alternative C:

Substitute $1,000,000 for impact and 40% for the probability of occurrence in the above formula.

$\begin{array}{c}\text{Residual}\text{risk}=\$1,000,000\times 40\%\\ =\$400,000\end{array}$

Therefore, residual risk for alternative A, B, and C is $48,750, $105,000, and $400,000 respectively.

3.

To determine

Compute benefit from each of the three alternatives.

Answer to Problem 27BEB

Benefit from alternatives A, B, and C is $351,250, $295,000, and $0 respectively.

Explanation of Solution

Benefit from a risk response alternative can be computed by using the following formula:

$\text{Benefit}=\text{Inherent}\text{risk}-\text{Residual}\text{risk}$

Computation of response benefit from alternative A:

Substitute $400,000 for inherent risk and $48,750 for residual risk in the above formula.

$\begin{array}{c}\text{Benefit}=\$400,000-\$48,750\\ =\$351,250\end{array}$

Computation of response benefit from alternative B:

Substitute $400,000for inherent risk and $105,000 for residual risk in the above formula.

$\begin{array}{c}\text{Benefit}=\$400,000-\$105,000\\ =\$295,000\end{array}$

Computation of response benefit from alternative C:

Substitute $400,000for inherent risk and $400,000 for residual risk in the above formula.

$\begin{array}{c}\text{Benefit}=\$400,000-\$400,000\\ =\$0\end{array}$

Therefore, benefit from alternatives A, B, and C is $351,250, $295,000, and $0 respectively.

4.

To determine

Compute net benefit from each of the three alternatives.

Answer to Problem 27BEB

Net benefit from alternatives A, B, and C is $150,000, $100,000, and $0 respectively.

Explanation of Solution

Net benefit from a risk response alternative can be computed by using the following formula:

$\text{Net}\text{benefit}=\text{Response}\text{benefit}-\text{Response}\text{cost}$

Computation of net benefit from alternative A:

Substitute $351,250 for response benefit and $201,250 for response cost in the above formula:

$\begin{array}{c}\text{Net}\text{benefit}=\$351,250-\$201,250\\ =\$150,000\end{array}$

Computation of net benefit from alternative B:

Substitute $295,000 for response benefit and $195,000 for response cost in the above formula:

$\begin{array}{c}\text{Net}\text{benefit}=\$295,000-\$195,000\\ =\$100,000\end{array}$

Computation of net benefit from alternative C:

Substitute $0 for response benefit and $0 for response cost in the above formula:

$\begin{array}{c}\text{Net}\text{benefit}=\$0-\$0\\ =0\end{array}$

Therefore, net benefit from alternatives A, B, and C is $150,000, $100,000, and $0 respectively.

5.

To determine

Identify the alternative which would be adopted by the company.

Explanation of Solution

Alternative A would be chosen by the company since; net benefit is highest in case of alternative A.