Question

Able Inc. sells a new product with a 2-year warranty. The company estimates that during the two years, the costs and related probabilities are: Year 1: $10,000 (20%) and $20,000 (80%); Year 2: $15,000 (50%); $25,000 (50%).The company's effective interest rate is 4%. Assuming the warranty costs are settled at the end of Years 1 and 2, calculate the estimated warranty liability using the expected cash flow method.

Answer 1

Answer: $35,798.82

Step-by-step explanation:

Find the expected warranty costs and then discount them using the effective interest rate:

Year 1:

= (10,000 * 20%) + (20,000 * 80%)

= $18,000

Year 2:

= (15,000 * 50%) + (25,000 * 50%)

= $20,000

Estimated warranty liability is the present value:

= 18,000 / (1 + 4%) + 20,000 / (1 + 4%)²

= $35,798.82