International Evidence on Financing of R&D

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, 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 firm-specific 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).