Table2reveals that there are quantitative differences between the static and dynamicspecifications. In particular, when the maximum number of new product lines that can bedeveloped following an innovation is low, firms initially select a low debt level and cannotreadjust in the static debt case. This implies that the average firm has a lower leverage ratioin the static debt case than in the dynamic debt model.Finally, because the model withdynamic debt generates the same qualitative results than the model with static debt, wefocus hereafter on analyzing the predictions of the model with static debt.Table4shows how changes in the firm’s environment affect outcome variables in thestatic debt case. The table illustrates that frictions (i.e. the corporate tax rate or the cost ofissuing debt) and the quality of the firm’s investment opportunity set have important effectson financing decisions and the industry turnover rate (Supplementary Appendix C reports asimilar table for the dynamic debt case). The next section provides an in-depth analysis ofthe relation between debt financing, innovation, and competition.CInteraction of Investment and Financing PoliciesIn the model, firms determine their investment policy by balancing the benefits and costsassociated with each type of R&D investment.Firms increase investment in innovationintensityλand qualityθas long as the marginal benefits outweigh the marginal costs. Themarginal benefits follow from the cash flow generated by new product lines and the marginalcosts are those associated with performing R&D.Shareholders choose a leverage ratio that balances the marginal benefits and marginalcosts of debt.Interest expenses on debt are tax deductible, which gives shareholders anincentive to issue debt. The presence of debt gives shareholders an option to default, which19
Comparative statics.All values are in %.LeverageMeanLeverageVarianceValue p.p.MeanTaxbenefitTurnoverrateEntry costH= 2.6727.382.240.374.112.87H= 521.472.240.413.221.21H= 7.3320.992.220.393.150.71Tax rateπ= 0.1019.281.790.411.931.17π= 0.1521.472.240.413.221.21π= 0.2029.843.750.395.971.53Max # new products per innovationn= 234.424.820.305.161.01n= 321.472.240.413.221.21n= 420.351.790.473.051.52Debt issuance costξ= 0%21.812.400.413.271.23ξ= 1.09%21.472.240.413.221.21ξ= 4.36%21.272.130.413.191.16Innovation cost curvatureγ= 0.31320.941.840.001.853.14γ= 0.32821.292.120.451.533.19γ= 0.34521.472.240.411.213.22Innovation intensity: scaleβi= 1818.581.820.491.042.79βi= 2621.472.240.413.221.21βi= 3427.813.520.351.384.17Table 3:Comparative statics of selected moments.20
is costly. Debt also reduces the benefits of innovation to shareholders because part of thebenefits 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 whichinfluences the optimal leverage choice. Firms’ investment and financing policy are thereforejointly determined. We illustrate these mechanisms below.