Research And Development: Expected Rate of Return and Cost of Funds

Research and development (R&D) is the process of developing inventions and innovations that increases the firm's profits either by increasing revenue or decreasing average total costs, or both.

Graph showing the relative amounts of research and development by firms in different economic market models, with monopolistic competition firms and oligopolistic firms doing more R&D than firms under pure competition or that have a monopoly.
How much should a firm spend on R&D? It all depends on the type of business. If the firm is in a monopolistically competitive market, then it will probably have to spend some money for R&D, not only to develop new products but also to develop more cost-effective ways of producing the product. Likewise for a firm in an oligopoly. Although firms in an oligopoly have less competition, they still can increase profits by developing new products and lowering their cost of production. Firms in competitive markets on the other hand, invest little in R&D, since they are selling a commodity product, which is often a natural resource product, such as agricultural products or mineral resources. A monopoly will also spend less on R&D, since it is not under any competitive pressures, although most monopolies must do some R&D, since evolving technology eventually erodes their market power. When the amount of R&D investment by firms in different economic market models is plotted against the industry concentration ratio, the graph has an inverted-U shape, which is sometimes referred to as the Inverted-U Theory of R&D Expenditures.

Like many other activities in economics, one should do something as long as the marginal benefit is greater than the marginal cost, which maximizes profits. Of course, this is a reasonable economic principle that is simple in concept, but difficult to do in actuality, since the benefits of an R&D project are hard to ascertain before the results are obtained, especially when it is in the development of a new product. Because many problems can arise in R&D, it is also difficult to project costs. Hence, in most cases, whether marginal benefit exceeds marginal cost will depend on the opinion of the entrepreneur or the executives of the firm.

Cost Of Funds

Businesses that engage in R&D must find a source of funds for financing. There are several possibilities. For entrepreneurs or startup firms, there is personal financing, where the entrepreneurs can tap their own personal sources of funds, such as personal savings or other investments or even credit cards. Some startup firms with large capital requirements can also obtain venture capital, which is money supplied by wealthy individuals or venture capital funds in return for an equity stake in the company.

Larger firms can use retained earnings, which is the accumulated profit of a firm that is not distributed as dividends. Large, creditworthy firms can also issue bonds, which are debt securities, using the services of an investment bank to manage the offering and to sell it to investors. Businesses organized as corporations can also issue stock, where the firm acquires money from investors in return for giving an equity stake to the stock buyers. The advantage of bonds over stocks is that the bondholders have no equity stake in the company, and therefore, do not share in the profits. Moreover, bond interest is tax-deductible. However, the interest on bond payments must be paid when they are due, even if the corporation is financially stressed. The advantage of stocks is that they do not pay dividends if the money can be better put to use to grow the company. The company has the option of discontinuing the payment of dividends, if the company suffers from financial hardship. However, dividends are not tax-deductible to the corporation. Indeed, both the corporation and the stockholders that receive the dividends must pay taxes on them.

Another source of funds for firms of all sizes is bank loans. The advantage of bank loans over issuing bonds is that it is cheaper to borrow from the bank than it is to issue bonds if the requirements for capital are small, since investment banks may receive 10% or more of the offering, especially for smaller or riskier firms. Although a firm can generally get a better interest rate by issuing bonds, there is an administration cost to issuing bonds, and the firm may not get the money that it expected, thus, requiring it to pay a higher yield.

A pertinent factor in considering the use of any funding is the interest rate cost of the funds. Even if the firm does not borrow money, there is still an opportunity cost of using available funds, such as personal savings or retained earnings. This opportunity cost is represented by the interest rate that could be earned if the money was placed in an interest paying deposit account or lent out in some other manner. Hence, the cost of all types of funding can be represented as an interest-rate cost of funds.

Expected Rate Of Return

A firm assesses the benefit of a R&D project by determining what its expected rate of return is, which is the amount expected to be earned over and above the amount invested divided by the amount invested.

Expected Rate of Return = Expected Return/Amount Invested

So, for instance, if a firm invests $1 million in a project and expects to earn $1.3 million, then the expected rate of return is 30%, which is equal to 300,000 divided by 1 million.

Firms engaged in R&D typically consider a number of research projects and they will try to determine what the expected rate of return will be for each project. Obviously, some projects will have a higher expected rate of return than others, so the firm will give priority to those projects with the higher expected rate of return. When graphed, the expected rate of return forms a downward sloping curve or line.

Graph showing how the expected return of research and development can be maximized by doing all R&D projects where the expected return is greater than the cost of funds for financing those projects.
Profit is maximized by doing all R&D projects where the marginal benefit is greater than the marginal cost. This is the point where the expected rate of return curve intersects the interest rate cost of funds curve. However, the firm may not be able to afford that much R&D, so naturally, the firm will choose those projects that have the highest expected rate of return and where there is confidence that the project is achievable.

There is always a great deal of risk in R&D, because neither actual benefits nor actual costs can be determined with certainty before the project is started. Nonetheless, many firms must engage in R&D; otherwise, they may lose significant market share to firms with superior products or lower costs of doing business.