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.