Question
Discount Rates, Automated Manufacturing, Competing Investments For discount factors use Exhibit 12B-1 and Exhibit 12B-2. Patterson Company is considering two competing investments. The first is
Discount Rates, Automated Manufacturing, Competing Investments
For discount factors use Exhibit 12B-1 and Exhibit 12B-2.
Patterson Company is considering two competing investments. The first is for a standard piece of production equipment. The second is for computer-aided manufacturing (CAM) equipment. The investment and after-tax operating cash flows follow:
Year | Standard Equipment | CAM Equipment |
0 | $(500,000) | $(2,000,000) |
1 | 300,000 | 100,000 |
2 | 200,000 | 200,000 |
3 | 100,000 | 300,000 |
4 | 100,000 | 400,000 |
5 | 100,000 | 400,000 |
6 | 100,000 | 400,000 |
7 | 100,000 | 500,000 |
8 | 100,000 | 1,000,000 |
9 | 100,000 | 1,000,000 |
10 | 100,000 | 1,000,000 |
Patterson uses a discount rate of 18% for all of its investments. Patterson's cost of capital is 10%.
Required:
1. Calculate the NPV for each investment by using a discount rate of 18%. Use the minus sign to indicate a negative NPV.
Standard equipment | $fill in the blank 1 |
CAM equipment | $fill in the blank 2 |
2. Calculate the NPV for each investment by using a discount rate of 10%.
Standard equipment | $fill in the blank 3 |
CAM equipment | $fill in the blank 4 |
3. Conceptual Connection: Which rate should Patterson use to compute the NPV? Explain. Notice how the cash flows using a 10% rate in Years 810 are weighted compared to the 18% rate. The difference in present value is
significantinsignificant
. Using an excessive discount rate works
againstfor
those projects that promise large cash flows later in their lives. The best course of action for a firm is to use its
10%18%
as the discount rate. Otherwise, some very attractive and essential investments could be overlooked.
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