Table 2 reveals that there are quantitative differences between the static and

Table 2 reveals that there are quantitative

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Table 2 reveals that there are quantitative differences between the static and dynamic specifications. In particular, when the maximum number of new product lines that can be developed following an innovation is low, firms initially select a low debt level and cannot readjust in the static debt case. This implies that the average firm has a lower leverage ratio in the static debt case than in the dynamic debt model. Finally, because the model with dynamic debt generates the same qualitative results than the model with static debt, we focus hereafter on analyzing the predictions of the model with static debt. Table 4 shows how changes in the firm’s environment affect outcome variables in the static debt case. The table illustrates that frictions (i.e. the corporate tax rate or the cost of issuing debt) and the quality of the firm’s investment opportunity set have important effects on financing decisions and the industry turnover rate (Supplementary Appendix C reports a similar table for the dynamic debt case). The next section provides an in-depth analysis of the relation between debt financing, innovation, and competition. C Interaction of Investment and Financing Policies In the model, firms determine their investment policy by balancing the benefits and costs associated with each type of R&D investment. Firms increase investment in innovation intensity λ and quality θ as long as the marginal benefits outweigh the marginal costs. The marginal benefits follow from the cash flow generated by new product lines and the marginal costs are those associated with performing R&D. 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 19
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Comparative statics. All values are in %. Leverage Mean Leverage Variance Value p.p. Mean Tax benefit Turnover rate Entry cost H = 2 . 67 27.38 2.24 0.37 4.11 2.87 H = 5 21.47 2.24 0.41 3.22 1.21 H = 7 . 33 20.99 2.22 0.39 3.15 0.71 Tax rate π = 0 . 10 19.28 1.79 0.41 1.93 1.17 π = 0 . 15 21.47 2.24 0.41 3.22 1.21 π = 0 . 20 29.84 3.75 0.39 5.97 1.53 Max # new products per innovation n = 2 34.42 4.82 0.30 5.16 1.01 n = 3 21.47 2.24 0.41 3.22 1.21 n = 4 20.35 1.79 0.47 3.05 1.52 Debt issuance cost ξ = 0% 21.81 2.40 0.41 3.27 1.23 ξ = 1 . 09% 21.47 2.24 0.41 3.22 1.21 ξ = 4 . 36% 21.27 2.13 0.41 3.19 1.16 Innovation cost curvature γ = 0 . 313 20.94 1.84 0.00 1.85 3.14 γ = 0 . 328 21.29 2.12 0.45 1.53 3.19 γ = 0 . 345 21.47 2.24 0.41 1.21 3.22 Innovation intensity: scale β i = 18 18.58 1.82 0.49 1.04 2.79 β i = 26 21.47 2.24 0.41 3.22 1.21 β i = 34 27.81 3.52 0.35 1.38 4.17 Table 3: Comparative statics of selected moments. 20
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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 then feed back into firms’ cash flow dynamics which influences the optimal leverage choice. Firms’ investment and financing policy are therefore jointly determined. We illustrate these mechanisms below.
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