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1Copyright©2014PearsonEducation,Inc.CorporateFinance,3e(Berk/DeMarzo)Chapter30RiskManagement30.1InsuranceUsethefollowinginformationtoanswerthequestion(s)below.ReardenMetalimportsorefromSouthAmerica.ReardenMetalisworriedthattheSouthAmericanminesmayenterintoalong-termcontractwiththeChinesetosellalloftheiroreoutputtoChina,hencecuttingoffReardenMetal'ssupply.IntheeventofsuchacontractwiththeChinese,ReardenMetalwillfacemuchhighercostsforitsrawmaterialscausingitsoperatingprofitstodeclinesubstantiallyanditsmarginaltaxratetofallfromitscurrentlevelof35%downto10%.AninsurancefirmhasagreedtowriteatradeinsurancepolicythatwillpayReardenMetal$2,500,000intheeventoftheSouthAmericansupplyoforebeingcutoff.ThechanceoftheSouthAmericansupplybeingcutoffisestimatedtobe20%,withabetaof-2.0.Therisk-freerateofinterestis4%andthereturnonthemarketisestimatedtobe12%.1)Theactuariallyfairpremiumforthisinsurancepolicyisclosestto:A)$417,000B)$446,000C)$500,000D)$568,000Answer:DExplanation:D)rL=rf+βL(rm-rf)=4%+(-2.0)(12%-4%)=-12%InsurancePremium===$568,000Diff:2Section:30.1InsuranceSkill:Analytical2Copyright©2014PearsonEducation,Inc.2)Rearden'sNPVforpurchasingthispolicyisclosestto:A)$32,500B)$56,750C)$142,000D)$156,250Answer:CExplanation:C)rL=rf+βL(rm-rf)=4%+(-2.0)(12%-4%)=-12%InsurancePremium===$568,000NPV=-Premium(1-Thigh)+×Pr(Loss)×Payment×(1-Tlow)=-568,182(1-.35)+(.20)($2,500,000)(1-.10)=$142,045Diff:3Section:30.1InsuranceSkill:Analytical3)Toinsuretheirassetsagainsthazardssuchasfire,stormdamage,vandalism,earthquakes,andothernaturalandenvironmentalrisksfirmscommonlypurchase:A)keypersonnelinsurance.B)businessliabilityinsurance.C)businessinterruptioninsurance.D)propertyinsurance.Answer:DDiff:1Section:30.1InsuranceSkill:Definition4)Tocoverthecoststhatresultifsomeaspectofthebusinesscausesharmtoathirdpartyorsomeoneelse'spropertyafirmwouldpurchase:A)businessinterruptioninsurance.B)propertyinsurance.C)businessliabilityinsurance.D)keypersonnelinsurance.Answer:CDiff:1Section:30.1InsuranceSkill:Definition3Copyright©2014PearsonEducation,Inc.5)Toprotectthefirmagainstthelossofearningsifthebusinessoperationsaredisruptedduetofire,accident,orsomeotherinsuredperilafirmwouldpurchase:A)propertyinsurance.B)keypersonnelinsurance.C)businessliabilityinsurance.D)businessinterruptioninsurance.Answer:DDiff:1Section:30.1InsuranceSkill:Definition6)Insurancethatcompensatesforthelossorunavoidableabsenceofcrucialemployeesinthefirmiscalled:A)keypersonnelinsurance.B)businessliabilityinsurance.C)propertyinsurance.D)businessinterruptioninsurance.Answer:ADiff:1Section:30.1InsuranceSkill:Definition7)Inrealitymarketimperfectionsexistthatcanraisethecostofinsuranceabovetheactuariallyfairpriceandoffsetsomeofthesebenefits.TheseinsurancemarketimperfectionsincludeallofthefollowingEXCEPT:A)adverseselection.B)agencycosts.C)administrativeandoverheadcosts.D)taxationofinsurancepayments.Answer:DDiff:2Section:30.1InsuranceSkill:Conceptual4Copyright©2014PearsonEducation,Inc.8)WhichofthefollowingstatementsisFALSE?A)Notallinsurableriskshaveabetaofzero.Somerisks,suchashurricanesandearthquakes,createlossesoftensofbillionsofdollarsandmaybedifficulttodiversifycompletely.B)Whenafirmbuysinsurance,ittransferstheriskofthelosstoaninsurancecompany.Theinsurancecompanychargesanupfrontpremiumtotakeonthatrisk.C)Byitsverynature,insurancefornon-diversifiablehazardsisgenerallyapositivebetaasset;theinsurancepaymenttothefirmtendstobelargerwhentotallossesarelowandthemarketportfolioishigh.D)Becauseinsuranceprovidescashtothefirmtooffsetlosses,itcanreducethefirm'sneedforexternalcapitalandthusreduceissuancecosts.Answer:CExplanation:C)Byitsverynature,insurancefornon-diversifiablehazardsisgenerallyanegativebetaasset(itpaysoffinbadtimes);theinsurancepaymenttothefirmtendstobelargerwhentotallossesarehighandthemarketportfolioislow.Diff:2Section:30.1InsuranceSkill:Conceptual9)WhichofthefollowingstatementsisFALSE?A)Becauseinsurancereducestheriskoffinancialdistress,itcanrelaxthistradeoffandallowthefirmtoincreaseitsuseofdebtfinancing.B)Byloweringthevolatilityofthestock,insurancediscourageconcentratedownershipbyanoutsidedirectororinvestorwhowillmonitorthefirmanditsmanagement.C)Whenafirmissubjecttograduatedincometaxrates,insurancecanproduceataxsavingsifthefirmisinahighertaxbracketwhenitpaysthepremiumthanthetaxbracketitisinwhenitreceivestheinsurancepaymentintheeventofaloss.D)Inaperfectmarketwithoutotherfrictions,insurancecompaniesshouldcompeteuntiltheyarejustearningafairreturnandtheNPVfromsellinginsuranceiszero.TheNPViszeroifthepriceofinsuranceequalsthepresentvalueoftheexpectedpayment;inthatcase,wesaythepriceisactuariallyfair.Answer:BExplanation:B)Byloweringthevolatilityofthestock,insurancecanencourageconcentratedownershipbyanoutsidedirectororinvestorwhowillmonitorthefirmanditsmanagement.Diff:2Section:30.1InsuranceSkill:Conceptual5Copyright©2014PearsonEducation,Inc.Usetheinformationforthequestion(s)below.Yourfirmfacesan8%chanceofapotentiallossof$50millionnextyear.Ifyourfirmimplementsnewsafetypolicies,itcanreducethechanceofthisloss