6. Your company has bought a new machine which is covered by a manufacturer\'s w

Question

6. Your company has bought a new machine which is covered by a manufacturer's warranty for the first year. The expected future repair costs are shown below. For simplicity, assume that costs are paid at the end of the year in which they are incurred. Year 123 45 Repair Cost (S)500| | ,000| 1500| 2,000 The seller is offering a 5-year extended service contract covering all repairs for an annual price of S960 starting at the end of year 1 and payable yearly until the end of year 5. Would you advise your boss to buy the service contract or not? Assume the interest rate is 7% per year.

Explanation / Answer

In order to advise the boss to buy the service contract or not, we have to compare the present value of the service contract and the present value of the expected cost if we do not take the service contract.

In order to maximize profits, we need to minimize the costs. So we will select the option with the least present value of costs.

v = 1/(1+i) = 1/(1+0.07) = 1/1.07 is the discounting factor.

Present value of expected cost = 0×v + 500×v² + 1000×v³ + 1500×v + 2000×v^5 = $3,823.3324

The present value of the service contract = 960 ( v + v² + v³ + v + v^5)

= 960 ( 4.100197) = $3,936.189

Here, the present value of expected costs is $3,823.3324

And, the present value of service contract is $3,936.189

Since the present value of costs without taking the service contract is lower, we would advise the boss to not buy the service contract.

Related Questions

Navigate

• Browse (All)
• Browse 6
• Subjects

---

---

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.