Question

Smith Legal Services has offered to represent a plaintiff in a lawsuit for a retainer of $20,000 plus 40% of any award over $20,000. Smith expects to incur out-of-pocket expenditures of $15,000 in litigating the suit. Possible court awards with their associated probabilities are:

Award -----Probability
$100,000 -----0.7
$0 ------------0.3

What is the expected value to Smith of the lawsuit?

A.$25,900
B.$27,400
C.$33,000
D.$37,000

Answer 1

The expected value to Smith Legal Services of the lawsuit is $27,400, which is calculated by determining the returns for each potential court award and considering the corresponding probabilities.

Step-by-step explanation:

To calculate the expected value to Smith Legal Services of the lawsuit, we must consider the possible outcomes and their respective probabilities.

Here are the steps we follow:

1. First, we calculate the returns for each possible award:
2. If the award is $100,000, Smith's returns would be $20,000 (retainer) + 40%×($100,000 - $20,000) - $15,000 (out-of-pocket costs). This equals $20,000 + $32,000 - $15,000 = $37,000.
3. If the award is $0, Smith's returns would be just the retainer minus the costs, which is $20,000 - $15,000 = $5,000.
4. Next, we compute the expected value by multiplying each outcome by its probability and summing the products:
5. ($37,000 × 0.7) + ($5,000 × 0.3) = $25,900 + $1,500 = $27,400.

Therefore, the expected value to Smith of the lawsuit is $27,400.