Introduction
Lakes Plc is currently planning for expansion and growth, there are two options available to the company, first option is to develop a new product in-house; second option is to buy a developed product from third party and sell globally. The details of the two options and the estimated cash inflow are summarized in Table 1.
Table 1 | First Option * | Second Option ** |
Description of Investment | To develop a new product in-house | To buy a new developed product from third party |
Initial Investment | $2 million | $1 million |
Year | Cash Inflow | |
1 | $0 | $100,000 |
2 | $0 | $100,000 |
3 | $0 | $100,000 |
4 | $0 | $100,000 |
5 | $0 | $100,000 |
6 | $0 | $200,000 |
7 | $0 | $300,000 |
8 | $0 | $250,000 |
9 | $0 | $200,000 |
10 | $600,000 | $180,000 |
11 | $600,000 | $120,000 |
12 | $800,000 | $100,000 |
13 | $1,200,000 | $50,000 |
14 | $1,500,000 | $30,000 |
15 | $2,500,000 | $20,000 |
Note:
* :- The in-house developed product is expected to have great demand in future and it requires high technology and initial investment, therefore the cash inflow is expected to increase substantially upon the product is market globally.
* *: - The new developed product (second option) purchased from third party is easily intimated, as such the cash inflow will be reduced since year 10.
# :- The company cost of capital is 10%
Based on the above table, it appears that both options are profitability (fifteen years cash inflow exceed the initial investment). However, Lakes Plc does not have sufficient fund to finance the both projects, and TBC….
Financing Methods
The financing decision is relatively important to other financial decision. Poor financing decision will lead to poor capital structure, resulting in high cost of capital, thereby lowering the net present value of a project and making more of the project unacceptable. An effective capital structure can lower the cost of capital, resulting in higher net present value and more acceptable project (Myers, 1984)t. Debt and equity are the two different sources of funds for a company. As both involve costs to the company, there is a need for the company to choose the right option that minimizes its costs and in most cases, companies tend choose to create the right combination of debt and equity that might result in the lowest costs (Gitman , 2002).
The two basis sources of debt capital are corporate bond and term loan granted by financial institutions (Gitman, 2003). TBC….
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Debt Financing
The merits of debt financing are summarized below:-
Maintain ownership of company. The major difference between the two methods of financing is that equity requires Lakes Plc to give up its partial ownership. Debt capital however, allows the existing shareholders of Lakes Plc to keep all ownership in return for interest and principal payments. If the existing shareholders of Lakes Plc might have trouble with giving up ownership of their company, as is the case with equity financing. They might not want the influences TBC….
