The reaction of diazomethane with ethylene in the presence of palladium diformate has been studied through density funcional calculations. Several mechanistic paths leading to the formation of cyclopropane have been studied. The results obtained show that the reaction of palladium diformate with diazomethane is more favorable than the reaction with ethylene. The reaction with diazomethane may lead to two different isomeric complexes: a methylene-inserted complex and a palladium-carbene complex. Insertion of methylene is the most favorable process, but the resulting complex is not suitable for cyclopropanation. The reaction with two additional diazomethane molecules makes the formation of the bismethylene-inserted palladium-carbene complex favorable. Attack of ethylene on this palladium-carbene complex leads to the formation of cyclopropane.