Scenario: John is planning to buy a cell phone. The market price of the cell phone is $200. While making the purchase, along with the regular replacement warranty for a year, he is also offered an extended warranty for 2 more years at a price of $50. The probability of the phone malfunctioning each year is 20 percent. It is also expected that a similar phone will cost $150 after the end of the first year and $100 after the end of the second year. The current market rate of interest is 10 percent.
-Refer to the scenario above.What is the value of having the extended warranty during the second year of ownership?

Question

Quizplus · Accepted Answer

To find the value of having the extended warranty during the second year of ownership, we need to calculate the expected cost of repairs without the warranty and subtract it from the cost with the warranty:

Cost without warranty = (0.2 x $150) + $100 = $130
Cost with warranty = $50 (since the warranty covers any repair costs)
Expected value of having the extended warranty during the second year = $130 - $50 = $80

Now we need to discount this expected value to the present using the market rate of interest:

Present value of having the extended warranty during the second year = $80 / (1 + 0.10)^2 = $62.18

Finally, we need to subtract the cost of the warranty to find the net benefit:

Net benefit of extended warranty during second year = $62.18 - $50 = $12.18

Since this is a positive value, it is worth purchasing the extended warranty. The best choice is therefore B.

Scenario: John Is Planning to Buy a Cell Phone