BWRR3033 Risk Management (A191)

Exercise-1 (NPV)

XYZ has a fire insurance policy with RM250 per occurrence deductible. XYZ is considering
to install fire sprinkler system in its production floor for an initial cost of RM1,500. The fire
sprinkler will last for three years. Annual upkeep cost of the fire sprinkler is expected to be
RM200. XYZ is expected to spend RM100 to dismantle the fire sprinkler at the end of year-
3. The fire sprinkler will be depreciated using simplified straight-line method over its usable
life. Without the installation of fire sprinkler system, the expected losses XYZ will
experience is RM2,500 per year and the annual fire insurance premium is RM1,500. With the
installation of fire sprinkler system, XYZ believes that its expected losses will be RM1,900
per year and the annual fire insurance premium will be RM1,200. XYZ’s opportunity cost of
capital for this decision is 10%. Note that insurance premium is paid at the beginning of the
year and it is a tax-deductible item. The corporate tax rate is 25%.

A. What is the NPV of installing fire sprinkler system?

(Round all amounts to the nearest dollar)

Year 0 1 2 3
RM RM RM RM
Lower Insurance Premium
Lower Expected Loss
Upkeep Cost
Dismantle Cost
Depreciation Expense
Before-Tax Earnings
Tax (25%)
After-Tax Earnings
Depreciation Reversal
Initial Investment Cost
Undiscounted Net Cash Flow
PVIF @ 10%
Discounted Net Cash Flow
NPV

Note the following:

Reduced in annual insurance premium =

Reduced in expected loss per year =
Annual depreciation expense =

B. Based on A above, should XYZ install the fire sprinkler system? Give reason to support
your answer.

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BWRR3033 Risk Management (A191)

C. If XYZ’s opportunity cost of capital is 18%, what is the NPV of installing fire sprinkler
system?

(Round all amounts to the nearest dollar)

Year 0 1 2 3
RM RM RM RM
Undiscounted Net Cash Flow
PVIF @ 18%
Discounted Net Cash Flow
NPV

D. Based on C above, should XYZ install the fire sprinkler system? Give reason to support
your answer.

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BWRR3033 Risk Management (A191)

Exercise-2 (NPV)

A company is evaluating a loss control plan. The costs and benefits are as follows:

Today End of Year 1 End of Years 2-5

RM RM RM
Loss Control Expenditures 10,000 2,000 0
Reduction in Expected Losses 0 3,000 4,000

Ignore the implications of possible reduced insurance premiums.

The company’s cost of capital is 7%.

A. What is the NPV of implementing the loss control plan?

(Round all amounts to the nearest dollar)

Today Year 1 Year 2 Year 3 Year 4 Year 5
RM RM RM RM RM RM
Loss Control
Expenditure
Reduction in
Expected Loss
Undiscounted NCF
PVIF @ 7%
Discounted NCF
NPV
Note: NCF is net cash flow.

or

NPV
= PV (Reduction in Expected Losses) – PV (Loss Control Expenditure)

B. Should the company implement the loss control plan? Give reason to support your
answer.

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BWRR3033 Risk Management (A191)

Exercise-3 (Cost Benefit Analysis)

ABC has a fertilizer plant. If an explosion occurs at the plant, the expected loss to society
will be RM300 million. However, the probability of an explosion at the plant can be reduced
depending on how much ABC spends on safety as shown by the table below:

Safety Expenditure Probability of Loss

In RM million
0.0 0.030
0.4 0.020
0.8 0.016
1.2 0.013
1.6 0.011
2.0 0.010

Answer the following questions based on the information given above:

A. How much ABC has to spend so that it is at the optimal level of safety?

Safety Probability Societal Expected Marginal Marginal

Expenditure of Loss Loss Loss Benefit Cost
RM million RM million RM million RM million RM million
(1) (2) (3)=(1)*(2)

B. What are the cost tradeoffs between two components of the cost of risk of ABC?

C. Provide two examples for each component of the costs of risk given in B above.