INTRODUCTION
The survey by Levine (2005) indicates that there is a strong relationship between financial development and economic growth. Recently, some studies have investigated the relationship between finance, innovation, and growth to explain specific channels for how financing creates growth.
These papers show that fluctuations in R&D expenditures of companies are associated with fluctuations in the availability of internal and external financial sources (Brown, et al., 2009; Martinsson, 2010). The evidence shown in these papers suggests that financing of innovation activities (mainly R&D expenditures) may be an important mediating variable explaining the finance-growth relationship. While Brown et al. (2009) test this relationship using a dataset consisting of 1,347 US companies,DOI: 10.4018/978-1-4666-6268-1.ch009
Martinsson (2010) uses data from 700 companies located in ten different European countries.1 Understanding the finance-growth relationship better at a broader perspective therefore urges for more research on the relationship between finance and innovation.
In this chapter, we elaborate on previous research by looking into the financing of R&D expenditures from an international perspective. In particular, we analyze the relationship between corporate R&D expenditures and the availability of financial resources using a large dataset consisting of almost 49,000 firm/year observations in 38 countries for the period 1980-2006. We investigate patterns of finance from three different angles.
First, we examine the role of different sources of finance in covering R&D expenditures. We focus on internal capital (cash flows) and equity finance. With respect to internal capital, we take into account the possibility that the relationship between this type of capital and R&D expenditures may be non-linear, an issue that has been raised recently in the literature on explaining financing of investment decisions in general.
According to this relationship, firm decreases their R&D at low level of cash flows and increases them at high level of cash flows. For a high level of R&D intensity, internal funds are not sufficient to cover all expenditures. The requirement of raising external financing opens the discussion of capital structure choice. There are several theories, such as pecking order and trade off theory dealing with market frictionless depending on information asymmetry, agency cost, or sources of capital to explain the proper debt-equity choice for financing of R&D investments. Since R&D expenditures indicate high growth opportunities with low liquidation value in the event of bankruptcy, equity finance can be considered as the optimal source for financing of R&D expenditures. With respect to equity capital, we investigate the role of using equity as such, as well as the extent to which firms issue new shares after periods when their shares are valued higher relative to their industry peers. Companies use this overvaluation for timing the market to issue new equity and, thus, temporarily reducing costs of capital. Both the issue of the non-linear relationship between internal capital and investment expenditures, as well as the market timing argument, have not been studied before in the context of financing R&D expenditures..
Second, when investigating financing patterns of R&D expenditures, we take into account firmspecific characteristics that may influence these patterns. In particular, we focus on whether or not firms are financially constrained (i.e. they have insufficient internal capital to finance their investment expenditures), because this may influence firms’ behavior regarding the issuing of new shares in periods during which shares are considered as being overvalued. Previous studies have shown that this matters for explaining financing patterns of investment expenditures (Campello & Graham, 2007).
Third, we investigate whether and how the context of financial market development influences financing patterns of R&D expenditures.
Our main premise to investigate this comes from the observation that R&D expenditures are constrained by access to finance and that these expenditures in most cases are financed either by internally available funds (i.e. cash flows) or by external equity. Yet, access to external finance may be conditional on contextual features such as the nature of national financial markets. As we will argue, access to external equity finance may be relatively easier in market-based financial systems, since equity markets are generally more developed. We are not aware of any study that looks into these issues using a large cross-country sample of firms.This chapter provides evidence supporting a U-shaped relationship between cash flows and R&D expenditures. Increases in cash flows elicit greater expenditures at higher level of cash flows. For high level of R&D, increasing in R&D is only possible with an increase in internal funds because raising additional debt financing creates additional risk. However, when cash flows are negative or perhaps small, firms decrease R&D expenditures to be able to cover their financing costs.
The results of this chapter also show that firms with high level of R&D expenditures use more equity financing. The argument for this finding is that for these firms, increases in R&D expenditures will be viewed at some point as risky and firms will respond by using more equity. The evidence for market timing is clear; there is a positive relationship between industry-adjusted market to book ratio and R&D. The conjecture may be that for these firms high market value relative to their book value lower the cost of equity and some firms respond it by investing more.
The relationships between R&D expenditures and three factors; internal funds, equity financing, and past market valuation, appear to exist only for firms that are ‘high users’ of R&D expenditures. The sensitivities of these variables are also different between financially constrained and unconstrained firms.
While the sensitivity of internal funds is higher for financially unconstrained firms, the sensitivity of equity financing is higher for financially constrained firms. Both types of firms use market-timing opportunities similarly.Regarding to comparison of market-based and bank-based countries, the data does not reveal similar evidence for firms in bank-based countries. This may be the result of closer firm-bank relationships in bank-based countries and favorable capital market conditions in market-based countries. Whereas firms have better access to external financing for the latter, banks continue to lend to firms in the first in spite of the riskier features of R&D investment being unpredictable, having lack of collateral value and high asymmetric information problem.
The remainder of this chapter is organized as follows. In the next section, we briefly discuss existing literature on the financing patterns of R&D and present my hypotheses related to the three different angles spelled out above. We proceed with the section for the methodology and the data, and then we discuss the outcomes of the empirical investigation regarding my hypotheses. In the last section, we provide conclusions of the chapter.