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.
Like many other activities in economics, a firm should do something as long as the marginal benefit exceeds the marginal cost, which maximizes profits. Of course, this is a reasonable economic principle, 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 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 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. Getting bank loans instead of issuing bonds is cheaper, 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 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 its expected rate of return, 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% (= 300,000 / 1,000,000)
Firms engaged in R&D typically consider a number of research projects and they will try to determine the expected rate of return 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 return. When graphed, the expected rate of return forms a downward sloping curve or line.
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.