Question

Your company's research and development department has been working on a new process that, if it works, can produce oil from coal at a cost of about $15 per barrel versus a current market price of $100 per barrel. The company needs $10 million of external funds at this time to complete the research. The results of the research will be known in about one year, and there is about a 50-50 chance of success. If the research is successful, your company will need to raise a substantial amount of new money to put the idea into production. Your economists forecast that although the economy will be depressed next year, interest rates will be high because of international monetary problems. You must recommend how the currently needed $10 million should be raised - as debt or as equity. How would the potential impact of your project influence your decision?

Answer 1

Company's Research and Development is working on a project which requires external funds to the extent of $10 million to complete the research at this initial phase. The probability of getting success in about one year is 50-50. If assumed that the company holds success at the end of the one year through this research exercise then it would further require more funds for the production phase of the company. It is predicted by the economists that the economy is going to see a depression phase in the next year due to the international monetary problems. So the interest rates are obviously going to increase in the market.

With such scenario being observed for the future economy it could be good for the company to opt for the equity funding. As equity funding would ensure such investors to the company who are interested in the concept of the company and not just for earning the fixed income for the capital invested. Even the investors would be the person to undertake risks for the capital invested in the company. This would enable the company to focus on the core objective of the compnay and not get pressurised about the interest obligations for any sort of debt.

In such a manner company would be able to save the cost of debt and could have such savings for the further growth requirements of the company.