Question

If an investment proposal is accepted for implementation and its payback period period is 3 years out of 5, is it virtually certain that the project will have to support for the first few years with capital from sources other than the cash generated from the projects. what are the implications of this multiyear cash requirement for the management. Will the implications be same if a new company with no other projects in line is evaluating the same project.

Answer 1

Nothing can be certain at this point as the project can be funded from either retained earnings or from external earnings. However since internal retained earnings are the cheapest form of the cash flows, there is a high probability that the cash flows shall be used from other projects of the company. The cash flows from the project itself can also be used to fund the project if there is capital requirement in following years. The fact that payback is 3 years out of 5, we can say that undiscounted cash flows can fund the cash requirements of the project easily.

The implications of multiyear cash requirements are that the managers have to maintain steady cash flow so that the project in not hindered. Also, the managers have to look for cheap sources of external funding if internal funds are not enough. The implications for a new company shall be similar, however this company shall be totally dependent on external sources of funds like owners equity or external debt financing. There would also be a difference in funding rate that this company receives. The debt may be priced higher as a new company has no operational history.