Question

Suppose a firm expects that a $20 million expenditure on R&D in the current year will result in a new product that can be sold next year. Selling that product next year would increase the firm’s revenue next year by $30 million and its costs next year by $29 million.

Instructions: Enter your answer as a whole number.

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?

      (Click to select)  Yes  No

c. Now suppose the interest-rate cost of borrowing falls to 4 percent. Will the firm undertake the project?

      (Click to select)  Yes  No

d. Now suppose that the firm has savings of $20 million—enough money to fund the R&D expenditure without borrowing. If the firm has the chance to invest this money either in the R&D project or in government bonds that pay 3.5 percent per year, which should it do?

      (Click to select)  Government bonds  R&D

e. What if the government bonds were paying 6.5 percent per year?

      (Click to select)  R&D  Government bonds

Answer 1

ANSWER:

Increase in firm's revenue next year = $30 million.

Increase in firm's costs next year = $29 million

Net gain from this R&D investment in next year = $30 million - $29 million= $1 million

R&D investment current year = $20 million

a)

We know that,

Expected Rate of Return is obtained by dividing the net gain from the investment with the cost of the investment.

Expected rate of return on this R&D expenditure

= $1 Million / $ 20 Million

= $ 0.05 million

It is equivalent to 5%.

b)

The firm can get loan at 6% interest to finance its $20 million R&D project and it expects to gain a return of 5% on the investment each year.

Here we can see that the expected return is less than the borrowing cost.

Hence the firm will not undertake the project.

Answer is NO.

c)

From the question we have 4% as the effective rate of borrowing.

Here we can see that expected return is greater than borrowing cost, so the firm will undertake the project.

Answer is YES.

d)

From the question we know that the firm has savings of $20 million—enough money to fund the R&D expenditure without borrowing.

The firm will like to invest in the R&D project because the interest of 3.5% by investing in government bonds is lesser than expected return on the given project.

e)

From the question we have that the government bonds were paying 6.5% per year.

Hence we can know that the return on the bonds is greater than the expected return on the project.

Hence the firm would invest in the government bonds.

Note: Please comment if you face any difficulty in understanding the solution. Please please upvote. Thank you.