P10–15 Internal rate of return Peace of Mind, Inc. (PMI), sellsextended warranties for durable consumer...

P10–15 Internal rate of return Peace of Mind, Inc. (PMI), sells extended warranties for durable consumer goods such as washing machines and refrigerators. When PMI sells an extended warranty, it receives cash up front from the customer, but later PMI must cover any repair costs that arise. An analyst working for PMI is considering a warranty for a new line of big-screen TVs. A consumer who purchases the 2-year warranty will pay PMI $200. On average, the repair costs that PMI must cover will average $106 for each of the warranty’s 2 years. If PMI has a cost of capital of 7%, should it offer this warranty for sale?

Solutions

Expert Solution

Cash received from consumer for 2 year warranty = $200

Annual repair expense = $106

Present value of annual repair expense = Annual repair expense x Present value annuity factor (r%, n)

= 106 x Present value annuity factor (7%, 2)

= 106 x 1.80802

= $191.65

Net present value of warranty = Cash received from consumer for 2 year warranty - Present value of annual repair expense

= 200 - 191.65

= $8.35

Since net present value of warranty is positive, hence warranty should be offered for sale.

ekkarill92 answered 2 years ago

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