Suppose a firm expects that a $40 million expenditure on R&D in the current year

Question

Suppose a firm expects that a $40 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 $60 million and its costs next year by $58 million.

Instructions: Enter your answer as a whole number.

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

b. Suppose the firm can get a bank loan at 4 percent interest to finance its $40 million R&D project. Will the firm undertake the project? (Click to select)YesNo.

c. Now suppose the interest-rate cost of borrowing rises to 6 percent. Will the firm undertake the project? (Click to select)NoYes.

d. Now suppose that the firm has savings of $40 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 6.5 percent per year, which should it do? (Click to select)Government bondsR&D.

e. What if the government bonds were paying 3.5 percent per year? (Click to select)R&DGovernment bonds.

Explanation / Answer

Increase in firm's Revenue Next year = $60m

Increase in firm's Expenditure Next year = $58m

Increase in firm's Net Profit Next year = $60m - $58m = $2 million

Investment Required this year = $40m

a) Expected Rate of Return = $2 million / $ 40 million = 5%

b) If bank can get loan at 4% for the $40 million investment, and it makes 5% on the investment each year, since the expected return > borrowing cost, the firm will undertake the project.

c) If cost of borrowing rises to 6%, since expected return < borrowing cost, the firm will not undertake the project.

d) If firm can get 6.5% by investing in government bonds, since that is greater than expected return on the given project, it should opt for invest in Government Bonds.

e) If firm can get 3.5% by investing in government bonds, since that is greater than expected return on the given project, it should opt for invest in the project.

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