Problem 1. An analyst knows with certainty that Skipper Inc. will exist for two years and have the following cash flows per share:
Year 1 Year 2
Revenue $100 $100
Costs $80 $80
Net cash flow $20 $20
What is the stock price of Skipper Inc. if the opportunity cost of capital is 8 percent?
Problem 2. The analyst in problem 1 realizes that Skipper Inc.'s costs may not be $80 per share with certainty. Instead, each year there is a 10 percent chance that a worker will be seriously injured and that Skipper will have to pay the employee's medical expenses and lost wages. If an injury does occur, Skipper's costs equal $85 per share. If an injury does not occur (which has a probability of 0.9), then Skipper's costs equal $79.445 per share.
a. What is Skipper's expected net cash flow in each year?
b. If the opportunity cost of capital is 8 percent, what is the stock price?
c. Provide an argument for why the opportunity cost of capital should not change because of the risk of worker injury.
Problem 3. Suppose that Skipper Inc. (from problem 2) purchases workers' compensation insurance to cover the costs of medical expenses and lost wages. The premium for full coverage is $0.555 per share. What is the stock price? Compare your answer to that obtained in 2(b) and intuitively explain the relationship.
Problem 4. Redo problem 3 using a premium of $0.75 per share. Compare your answer to that obtained in problem 3 and intuitively explain the relationship.
Problem 5. If the risk-free rate equals 7 percent and the risk premium for Thistle Corp. is 5 percent, what is the opportunity cost of capital for Thistle? Suppose Thistle purchases insurance to cover property damage. What is likely to happen to its opportunity cost of capital?