Unfortunately the premium loading is rarely zero

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the loading = 0, then purchasing insurance does not change a person’s expected wealth. Unfortunately, the premium loading is rarely zero since insurers must be compensated for their costs. Nonmonetary Losses can take the form of pain & suffering from physical injuries and grief when a loved one dies. People generally do not purchase insurance against nonmonetary losses, and is provided implicitly by the court system when injured parties receive compensation. Valuation Formula A business’s value is defined as the PV of its expected net cash flows: Outcome Probability End-of-Year Cash Flow No Lawsuit 0.9 $100 Lawsuit 0.1 100 – 30 = $70 Expected cash flow = 0.9(100) + 0.1(70) = $97 Value = 97 / (1 + 0.135) = $85.46/share The appropriate discount rate is called the opportunity cost of capital since it is the expected return an investor could have received had the person invested in a similar risk investment. a) Risk-free Rate of Return – no risk associated b) Risk Premium – additional expected return due to taking on risks a) Diversifiable Risk – risk that can be eliminated by investors by holding diversified portfolios - does NOT affect the opportunity cost of capital b) Nondiversifiable Risk – risk that cannot be eliminated by diversification - increases the opportunity cost of capital Diversifiable risk is also called firm-specific risk , idiosyncratic risk , or
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  • Winter '13
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