7.4 Your small company is a defendant in a lawsuit alleging that it produced a product that failed and harmed the purchaser. Although you believe your company is innocent, you think there is a 50 percent probability you will lose the suit. If you lose, you are uncertain what you will be required to pay. The following table shows your subjective probabilities of paying different amounts. Your litigation costs are $120,000.

a. What is the expected value of the sum of money you might have to pay?

b. Using the expected value of what you might be required to pay, what is your expected loss from litigation?

c. Your attorney notifies you that there is only a 9 percent chance you will be required to pay $110,000 if you lose, but there is now a 1 percent chance you will be required to pay $4 million if you lose. With these changes, what is the expected value of the sum of money you might be required to pay? What is your expected loss from litigation? How has this new information changed your willingness to settle the case, and why?

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Probability (percent) Loss 30 $35,000 20 $55,000 20 20 $65,000 10 $80,000 10 $100,000 10 $110,000