Question
ROSS and MIC produce 2 different cars. Each firm can be aggressive in advertising and marketing. If only one of the 2 firms choose high advertising the NPV of that firm would be $200M whereas the NPV of the other firm would be $100M. If both firm decide low advertising than the NPV of each car would be $500M. Draw the extensive form of the game.
Question: Explain the differences between technical risks, business risks, and competitive risks.
Technical risk refers to the likelihood of firm incurring losses due to operations such as manufacturing, design and engineering, tests procedures and technological processes. Technical risks can be measured by the efficiency of machines used in production, technological advancement and simulation analysis of technology used as output is increased.
Business risk refers to the likelihood that a company’s actual earnings will be not match the anticipated earnings or the company will attain a loss instead of a profit in the coming financial year. Business risk is caused by several factors such as; per-unit price, sales volume, input cost, government regulation and economic climate. Business risk is estimated using four key ratios; operation leverage, financial leverage, contribution margin and total leverage effect. A company can minimize its business risk by reducing the debt ratio in its capital structure so that it is able to meet it maturing obligation as and when they fall due. The company can also minimize its business risk by investing in products that have a contribution sufficient to meet its fixed costs.
Competitive risk is the likelihood that a firm will incur losses in future financial periods due to decline in the company’s competiveness. Competitive risk is analyzed through a SWOT analysis. SWOT stands for strengths, weaknesses opportunities and threats. Strengths are internal factors that give a firm a competitive edge over its competitors. Weaknesses are internal factors that reduce a firm’s competitive edge over its competitors. Opportunities are external factors that give a firm a competitive edge over its competitors. Threats are external factors that have a negative impact on a firm’s competiveness. To reduce competitive risks, firms should emphasis on its strengths and minimize its weaknesses. A firm has little control over its opportunities and threats since they are external.
Question: How do we finance R&D? Explain all the steps.
Financing research and development (R&D) activities are difficult in a free market place because of various reasons. The output of research and development is knowledge on how to produce new goods and/or service. This information is non-rival; that is use by one firm does not exclude other firms from using it. Therefore, returns on R&D investment cannot be attributed to the firm undertaking it alone. It is also difficult to value the cost of R&D since it is an intangible good. Financing R&D therefore follows different steps compared to financing other items.
The first step is to determine the R&D expenses to determine the financing needs. More than half of R&D expenses on human capital inform of wages to engineers, designers and scientist involved in the invention and design of the new products. The second step would be to determine changes in R&D over time and output produced. Generally R&D tends to respond slowly to time changes, capital cost changes and productivity. The next step would be to determine the expected returns on the R&D investments. Returns on R&D are evaluated using the marginal profit conditions. The marginal product (MP) of research and development capital is equals to the tax adjusted user cost of capital.
The next step would be to determine the source of financing. When cost of capital is considered, debt is cheaper than equity. However, providers of debt capital prefer tangible assets as collateral yet the product of R&D is an intangible asset. Lastly, the firm needs to consider agency costs because R&D investments have a higher uncertainty and risk than ordinary investments. This is because providers of debt capital prefer low risk investments to be assured of their investment while shareholders prefer high risk- high returns investments to maximize their wealth. Therefore, equity is normally the most appropriate source of financing for R&D.
References
Ehrhardt, M. C., & Brigham, E. F. (2008). Corporate Finance: A Focused Approach (3, illustrated ed.). London: Cengage Learning.
Metrick, A., & Yasuda, A. (2007). Venture Capital and the Finance of Innovation (2, illustrated ed.). New Jersey: John Wiley and Sons.
Vishwanath, S. R. (2007). Corporate Finance: Theory and Practice (2, illustrated ed.). New York: SAGE.
