Milker Corporation is considering buying View Farm, a 160-acre family-operated dairy farm located near a busy state highway in a suburban area. Over 90 percent of the farm’s $300 000 annual revenue is derived from sales of unprocessed milk and homemade ice cream. Two hundredths of one percent (0.0002) of the 180 000 retail customers who each year buy milk at View Farm claim to have been poisoned by the milk. Although the farm’s management believes that any poisoning is primarily caused by impurities already in the containers that customers bring to be filled, the fact that View milk is unprocessed leaves the farm particularly vulnerable to liability. Therefore, rather than go to court, the farm has been paying an average of $300 as a settlement to each person who claims to have been poisoned by the milk.

a. Calculate, with procedure, the annual expected value of the settlement payments that the farm has been making to customers claiming to have been poisoned.

b. Milker Corporation is considering buying View Farm for $1 000 000. Milker believes that the farm will be productive for 15 years and then will shut down and have no salvage value. Milker’s management wants an internal rate of return of at least 18%. Determine if Milker should buy this farm. (Take into account the cost of expected losses, and assume Milker’s tax rate is 35%)

c. Assume all the same facts as in part (b) above with the additional concern that Milker’s management believes that the uncertainty regarding liability needs to be factored into the analysis. Milker’s risk management professional has determined that the cost of uncertainty regarding liability should be $20 000 per year. Should Milker purchase the farm?

d. For an additional $100 000, Milker can purchase equipment with the farm that will process its milk (no poisonings risk) for the next 15 years, after which the equipment will have no salvage value. Calculate the internal rate of return.

e. Calculate the NPV and internal rate of return if, instead of purchasing the processing equipment, Milker purchased an annual general liability insurance that would cost $35 000 per year in premium and cover all liability claims.

f. Rank Milker’s choices from highest to lowest based on IRR for each of the following choices: buy View farm; buy View farm and the equipment; buy View farm and insurance; do noting ( i.e. cancel the plan of purchasing the View farm).

Answer rating: 100% (QA)

a Calculate with procedure the annual expected value of the settlement payments that the farm has been making to customers claiming to have been poisoned ANSWER The annual expected value of the settle... View the full answer