Abby has just negotiated a $15,000 price on a 2-year-old car and is with the salesman closing the deal. There is a 1-year sales warranty with the purchase; however, an extended warranty is available for $2500 that will cover the same repairs and component failures as the 1-year warranty for 3 additional years. Abby understands this to be a real options situation with the price of the option ($2500) paid to avoid future, unknown costs. To help with her decision, the salesman provided three typical sets of historical data on estimated repair costs for used cars. The first-year costs are shown as zero because they will be covered by the sales warranty.

The salesman said case C is the base case, since it shows that the extended warranty is not needed because the cost of repairs equals the warranty cost. Abby immediately recognized this to be the case only when i= 0%.
(a) If Abby assumes that each repair cost scenario has equal probability of occurring with her car, and money is worth 5% per year to her, how much should she be willing to pay for the extended warranty that is offered at $2500?
(b) If the base case actually occurs for her car and she does not purchase the warranty, what is the PW value of the expected future costs at i = 5% peryear?

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Year Repair cost, $ per year 500 1200-850 0 1000-1400400 0500 2000