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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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