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.
What cost-of-capital rate makes the royalty and lump sum payment alternatives equally acceptable?
What alternative is preferred if the company's cost of capital is in fact lower than this break-even rate?