Internal rate of return Peace of Mind, Inc. (PMI), sells extended warranties for

Question

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?

Explanation / Answer

We will offer this warranty, in order to take decision we have taken the following procesdures for the decision:

We have taken decision per the NPV and IRR:

Calculation of NPV:

NPV = 200 - (106/1.07^1 + 106/1.07^2)

NPV = 200 - (106/1.07^1 + 106/1.07^2) (Here 7% is the cost of capital)

            200-[99 .07+ 92.58]

            8.356 , As NPV is positive, we will except the proposal based on NPV.

IRR:

0 = CF0 – CF1/1+IRR + CF2/ (1+IRR)^2

          200 – 106/1+IRR – 106/(1+IRR)^2

          200 – 106/1.0397 – 106/(1.0397)^2

          200 – 101.95- 98.05

Therefore IRR = 3.97 which is less than 7%, we should offer this warranty

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