A manager believes there is a 10 percent chance their firm will have to pay $1,000,000 and a 90 percent chance they will be found innocent and pay nothing except the legal fees of $200,000. If the manager is offered a settlement deal of $300,000 (the manager's firm would pay the plaintiff $300,000), and the manager flips a coin to decide if they should settle or not, which of the following statements is true?

Question

Quizplus · Accepted Answer

The manager is risk-neutral because they are willing to accept a settlement offer that is in between the expected values of paying $1,000,000 or paying $200,000 in legal fees. The expected value of paying $1,000,000 is 0.10(1,000,000) = $100,000 while the expected value of paying only the legal fees is 0.90(0) - 0.10(200,000) = -$20,000. Therefore, the expected value of not settling is (-0.5)($100,000) + (0.5)($0) = -$50,000. Compared to this expected value, the settlement offer of $300,000 is more attractive to the manager since 300,000 > -50,000.

A Manager Believes There Is a 10 Percent Chance Their