Expected rate of return on this R&D expenditure and its R&D

Suppose a firm expects that a $20 million expenditure on R&D will result in a new product that will increase its revenue by a total of $30 million 1 year from now. The firm estimates that the production cost of the new product will be $29 million.

a. What is the expected rate of return on this R&D expenditure?
b. Suppose the firm can get a bank loan at 6 percent interest to finance its $20 million R&D project. Will the firm undertake the project? Explain why or why not.
c. Now suppose the interest-rate cost of borrowing, in effect, falls to 4 percent because the firm decides to use its own retained earnings to finance the R&D. Will this lower interest rate change the firm's R&D decision? Explain.

Solution Preview

a. What is the expected rate of return on this R&D expenditure?

As the revenue of new product is $30 million while the production cost of the new product will be $29, then the net income will be equal to $1 million.

Therefore, the expected rate of return on this R&D expenditure will be equal to

$1 million/$20 million = 5%

b. Suppose the firm can get a bank loan at 6 percent ...

Solution Summary

This solution is comprised of a detailed explanation to find the expected rate of return on this R&D expenditure and its R&D decision making.

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