BU353 Lecture Notes - Lecture 6: Cash Flow, Net Present Value
Chapter 6: Loss Control
Numerous activities reduce expected losses by reducing the frequency of losses (loss prevention). An
extreme example of loss prevention is to avoid completely the activity that potentially gives rise to the
loss (loss avoidance).
Activities that reduce expected losses by decreasing the size of the loss conditional on a loss occurring
are called loss reduction; they can occur before or after a loss. Pre-loss activities occur before a loss;
they decrease the magnitude of a loss if one occurs. Post-loss activities occur subsequent to an event
that causes a loss. An important type of pre-loss reduction activity is disaster response or catastrophe
planning.
Segregation of Exposure Units – when a firm diversifies risk by segregating loss exposures into smaller
exposure units; reduces the variance of direct losses and the maximum probable direct loss
Optimal loss control decisions required that loss control expenditures be made up to the point that the
marginal benefits no longer exceed the marginal costs. Directing resources towards safety measures
that are the most cost-effective saves lives and reduces the total cost of risk.
Loss control decisions often need to assess the value of human life.
The net present value often is written as the PV of net cash flows minus the initial cash outflow for the
investment.
Incremental expected cash flow example (fencing project)
This Year
Year 1
Year 2
Year 3
Capital investment
(150,000)
Reduction in theft
losses
55,000
55,000
55,000
Reduction in
security
15,000
15,000
15,000
Depreciation
50,000
50,000
50,000
Earnings before
interest & taxes
20,000
20,000
20,000
Taxes (34%)
6,800
6,800
6,800
After-tax earnings
13,200
13,200
13,200
Cash flow
adjustments:
Add depreciation
50,000
50,000
50,000
Expected net cash
flow
63,200
63,200
63,200
PV of cash flow
(10% discount rate)
(150,000)
57,454
52,231
47,483
NPV =
$7,169
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Document Summary
Numerous activities reduce expected losses by reducing the frequency of losses (loss prevention). An extreme example of loss prevention is to avoid completely the activity that potentially gives rise to the loss (loss avoidance). Activities that reduce expected losses by decreasing the size of the loss conditional on a loss occurring are called loss reduction; they can occur before or after a loss. Pre-loss activities occur before a loss; they decrease the magnitude of a loss if one occurs. Post-loss activities occur subsequent to an event that causes a loss. An important type of pre-loss reduction activity is disaster response or catastrophe planning. Segregation of exposure units when a firm diversifies risk by segregating loss exposures into smaller exposure units; reduces the variance of direct losses and the maximum probable direct loss. Optimal loss control decisions required that loss control expenditures be made up to the point that the marginal benefits no longer exceed the marginal costs.
