The methodology for the identification of R&D investment equations is based on a simple supply and demand heuristic, as shown in Figure 1. The curve sloping downward to the right represents the demand for R&D investment funds and the curves sloping upward the supply of funds. Internal funds are available at a constant cost of capital until they are exhausted, at which point it becomes necessary to issue debt or equity in order to finance more investment. When the demand curve cuts the supply curve in the horizontal portion, a shock that increases cash flow (and shifts supply outward) has no effect on the level of investment. R&D investment demand may be excessively sensitive to cash-flow shocks in liquidity- constrained firms.
EIB PAPERS Volume14 N°2 2009 17 Figure 1. Financially unconstrained firm Rate of return/Cost of funds cost of internal funds R&D Investment Demand for funds Supply of funds Supply of funds shifted out 0 10 0 1.2 A, B However, if the demand curve cuts the supply curve where it is upward sloping, it is possible for a shock to cash flow to shift the supply curve out in such a way as to induce a substantial increase in R&D investment. Figure 2 illustrates such a case, where the firm shifts from point A to point B in response to a cash flow shock that does not shift the demand curve. Figure 2. Financially constrained firm R&D Investment Rate of return/Cost of funds Demand for funds Supply of funds Supply of funds shifted out cost of internal funds 0 10 0 1.2 B A During the past several years, various versions of these methodologies have been applied to data on the R&D investment of US, U.K., French, German, Irish, and Japanese firms and possibly others. The firms examined are typically the largest and most important manufacturing firms in their economy. When does an increase in the supply funds lead to additional R&D investment?
18 Volume14 N°2 2009 EIB PAPERS For example, Hall (1992) finds a large positive elasticity between R&D and cash flow, using an accelerator-type model and a very large sample of US manufacturing firms. The estimation methodology here controls for both firm effects and simultaneity. Similarly and using some of the same data, Himmelberg and Petersen (1994) look at a panel of 179 US small firms in high-tech industries and find an economically large and statistically significant relationship between R&D investment and internal finance. More recently, J. Brown et al. (2009) have shown that both cash flow and the issuance of public equity are very important for younger US firms during the period 1990-2004, while they have little impact on mature firms’ R&D investment. They focus on the high-technology sector (drugs, office and computing equipment, communications equipment, electronic components, scientific instruments, medical instruments, and software), which accounts for almost all of the increase in R&D during this period, and use Euler-equation methods with fixed firm effects and industry-level year dummies to remove most of the variation due to unobserved differences in firm characteristics and demand shocks across industry.
- Spring '17