given by equation 7 binds This leads to a dampening of the effects of debt

Given by equation 7 binds this leads to a dampening

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(given by equation ( 7 )) binds. This leads to a dampening of the effects of debt financing on firm value. In our base case calibration, the entry condition binds for low p since the number of new products that can be developed following an innovation is low ( n = 3). III Financing Policy and Investment Opportunities Shareholders choose a leverage ratio that balances the marginal benefits and marginal costs of debt. Interest expenses on debt are tax deductible, which gives shareholders an incentive to issue debt. The presence of debt gives shareholders an option to default, which is costly. Debt also reduces the benefits of innovation to shareholders because part of the benefits of investment accrue to creditors (due to the fact that debt becomes less risky). Therefore, debt distorts innovation incentives and leads to underinvestment by incumbents. These distortions in innovation policy feed back into firms’ cash flow dynamics which influences the optimal leverage choice. Investment and financing policy are therefore jointly determined. To illustrate these mechanisms, Figure 8 shows how leverage is affected by several key parameters describing the quality of the firms’ investment opportunities: The cost function curvature γ , the cost function level β i , the maximum number of new products per innovation 29 Electronic copy available at:
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n , and the maximum number of product lines ¯ p . 0 . 33 0 . 335 0 . 34 0 . 345 0 . 35 0 . 355 0 . 36 0 . 15 0 . 2 0 . 25 0 . 3 Cost function curvature γ Mean leverage 20 22 24 26 28 30 32 0 . 15 0 . 2 0 . 25 0 . 3 Cost function level β Mean leverage 2 3 4 5 6 7 8 0 . 1 0 . 2 0 . 3 Max number of products per innovation n Mean leverage 23 24 25 26 27 0 . 15 0 . 2 0 . 25 0 . 3 Max number of product lines ¯ p Mean leverage Figure 8: Investment opportunities and financing policy. The figure shows the effects of the quality of investment opportunities on financing decisions. The comparative statics are smoothed using a third-order polynomial. Figure 8 shows that higher costs of innovation lower individual firms’ incentives to inno- vate, so that a smaller amount of their value comes from growth opportunities. In response, firms increase financial leverage. Figure 8 also shows that when each innovation has the po- tential of creating more product lines (as n gets larger), the potential costs of debt overhang are larger and firms issue less debt. The effect of changing ¯ p on leverage is more muted. This is due to the fact that ¯ p has been chosen large enough so that its effects on firm policies are limited. Overall, these results show that investment decisions feed back into financing choices. Our results are consistent with evidence in Smith and Watts ( 1992 ) and Barclay 30 Electronic copy available at:
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and Smith ( 1995 ) that firms with better growth opportunities adopt lower leverage ratios.
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