The Question II, Part 2,
The book suggests two alternatives: buying the expensive stereo with life time warranty and buying the inexpensive one with only one year warranty. The student is risk neuter.
The freshmen student has 50 % probability of buying the expensive stereo: .50 * $110 = $55 and $55-$110= -$55 (in the book, it is taken as -60 because of the 10% discount rate)
The student has 50 % probability of buying an inexpensive stereo. However, the student, in this case, should calculate the risks which are waiting for him. There is 50% chance that the stereo will not break down. In this case: $50* (.50) = 25 and $25- $50= -$25.
There is 25% chance that the inexpensive stereo breaks down in the 1 year. Therefore, he has to send the stereo to the company to repair or change it. This will cost him 20 more dollars:
$50 * .25= $12.5; and $12.5 + $20 = $32.5; therefore, $32.5 - $50= -$17.5 (in the book, it is taken as -17.05, probably because of the discount rate).
There is 25% chance that the inexpensive stereo breaks down at two years. In this case, the student has to buy a new one: For the two stereos: $50 * .25= 12.5 and 12.5/ (1-.10) = 13.88, if we multiply $13.88 with 2, the result is 27.76. Therefore, $27.76- $50 = -$22.24 (in the book it is given as -22.83).
There are some slight differences between my calculations and the book’s calculations. It is probably because of the fact that Munger (2000) probably uses professional techniques for the calculations, while I use a simple calculator.
If the student buys the inexpensive one: -25 + (-17.05) + (-22.83) = -64.88 and if he buys the expensive one, the value of outcome is -60. As a result it is more logical to by the expensive stereo rather than ...