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 third year of ownership?

Question

Quizplus · Accepted Answer

The expected cost of replacing the phone in the third year without a warranty is $100 (cost of a similar phone) multiplied by the probability of malfunctioning (20%), which equals $20. Discounting this amount back to present value using the market interest rate of 10% gives $20 / (1.1)^3 = $15.03.

Scenario: John Is Planning to Buy a Cell Phone