Given Corp plans to sell a machine with a 1-year warranty to J.R. Inc. There is a 2% probability Garven will lose a $1,000,000 lawsuit in the coming year. If this happens, Garven will go bankrupt and will not provide any warranty services to J.R. because J.R. views purchasing the machine from Garven is risky. J.R. will only pay $10,000 for the machine.

If Garven purchases a $1,000,000 liability insurance for $25,000, Garven is able to provide the promised warranty services to J.R. for sure in the next year. In this case, J.R. will pay $17,000 for the machine.

1a. What is the premium of this $1,000,000 liability insurance?

1. $5,000

2. $25,000

3. $20,000

4. $30,000

1b. What is Garvens net increase in the expected cash flow within this liability insurance?

1. 2,500

2. 1,500

3. 2,000

4. 1,000

1c. Which motivation for corporate risk management is illustrated in this example?

1. Mitigate financial distress and bankruptcy costs

2. Manage agency problems

3. Avoid costly external finance

4. Tax motivations