Suppose that a factory is located in a flood prone area. You have been hired to identify if the factory owner should increase the factory’s flood protection. Three options are being considered:
a) Do nothing. Damage from a moderate flood is $10,000 and $25,000 in a severe flood.
b) Perform a moderate amount of flood protection improvements for $15,000. There will be no damage from a moderate flood and $10,000 in damage from a severe flood.
c) Perform an extensive amount of flood protection for $25,000. There will be no damage from moderate or severe floods.
The annual flood risk is 0.7 for no flood, 0.2 for a moderate flood, and 0.1 for a severe flood. Assuming an interest rate of 15% and a 15 year analysis period, what would you recommend?
What is the standard deviation of the expected cost of each flood project in problem 3 above? Which option is least risky?