A major automotive company is considering an agreement with a small manufacturer

Question

A major automotive company is considering an agreement with a small manufacturer whereby it would be required to make end-of-the-year royalty payments of $500 000 beginning in year 4 and ending in year 8 (five years in total) An immediate lump sum payment of $1 500 000 is being considered as an alternative to this royalty scheme.

(i)What cost of capital rate makes the royalty and lump sum payment alternatives equally acceptable?

(ii) What alternative is preferred if the company’s cost of capital is in fact lower than this break even rate?

Explanation / Answer

1)

for finding out capital rate making royalty and lum sum payment equally acceptable we need to find out the cost of capital, r where present value of royalty is equal to immediate lumpsum payment

PV of Royalty= 5,00,000/(1+r)4 + 5,00,000/(1+r)5 + 5,00,000/(1+r)6 + 5,00,000/(1+r)7 + 5,00,000/(1+r)8

lumpsum payment= 1,500,000

so at that value of r when these two are equal, company will be indifferent

that r will be break even point

2)

if r< break even point, then PV of royalty will be greaterthan lumpsum payment, lump sum payment will be prefered.

Related Questions

Navigate

• Browse (All)
• Browse A
• Subjects

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.