R&D and Internal Finance: A Panel Study of Small Firms in High-Tech Industries, Himmerlberg and Petersen 1994

Intro: Since Shumpeter, economists have argued that internal finance is an important determinant of R&D investment. However, almost without exception, previous empirical studies have not found evidence of such a relationship. The authors try to investigate the relation with new data on small firms in high-tech industries using panel data analysis. The pecking order theory supports the relationship: moral hazard and adverse selection in debt and equity markets make the internal source of capital valuable.

The authors say Acs and Audretsch (1988) show that firms in small size account for a major fraction of new innovations in US manufacturing. I think they are talking about the external validity. Should we buy this story? This study is only on small firms in high-tech firms. It may have a strong internal validity, but I doubt the external validity of this study.

The reasons why the authors also examine the effect of internal finance on physical investment: 1) it allows them to compare their findings to the existing literature on physical investment under capital market imperfection, 2) it is inappropriate to strictly divide R&D and physical investment, and 3) new knowledge must be embodied in the production process through investment in new plant and equipment.

Main findings: Controlling for unobservable firm effects, they obtain a large and statistically significant relationship between both forms of investment (RD and physical) and internal finance. With-in firm estimates provide a downward bias if firms smooth R&D in response to transitory shock in cash flow. Using the IV approach, they find elasticities for R&D and physical investment are 0.067 and 0.822, respectively.

Empirical issues in previous studies: In R&D and internal financing literature, researchers only consider large firms which tend to generate much more cash flow than they need for investment purposes. In internal financing and physical investment literature, researchers find a statistically significant explanatory role of internal resources in explaining variations in physical investment.

The pecking order theory is based on the information asymmetry between firms and suppliers of external finance. Small and high-tech firms do have the issue.  Also for R&D projects the moral hazard problems are highly relevant since the output can never be predicted perfectly from the inputs. [unmonitored borrowers have an incentive to use loans for projects that are not in the best interest of lenders.]

Spence (1979) model: Profits are initially positive because industry capacity is low relative to demand. Each firm’s rate of growth is constrained by access to internal finance, so firms move along their expansion paths as rapidly as their internal finance permits. The production function includes not only a stock of capital but a stock of technology as well. The output is a homothetic function of tech and physical capital and that the stock of tech is acquired through R&D investment.

The authors assume that small, high-tech firms face a binding financial constraint on investment expenditures. My view: This makes the firms have high level of information asymmetry, and the internal finance valuable for investment.

If the production function were not homothetic, or if there were adjustment costs, then cash flow coefficients could be interpreted as a linear approximation of these shares over time period covered by their panel.

On adjustment costs: A large fraction of R&D is just a payment to high-skilled workers such as researchers and engineers. They cannot be alternatively fired and replaced easily. So the adjustment costs are very high, biasing the results.

An important step: to minimize both the current and future adjustment costs, firms set the level of R&D investment in accordance with the permanent level of internal finance. If the firm believed the shock for internal fund is transitory, it attempts to maintain the planned level of R&D by adjusting physical investment, or working capital. So, the authors decompose the current cash flow into a permanent and a transitory component.

Predictions: If R&D and physical investment were the only components of total investment, the cash flow coefficients would sum to one. But, it is not true in reality: thus the authors predict the coefficients should sum to a number that is large but less than one. Next, if adjustment costs are important, R&D may not respond equally to transitory and permanent cash flow shocks. Since the conventional with-in firm estimator does not capture the difference between the permanent and transitory downwarding the estimate, using IV is better to control this bias and allows for the existence of individual firm effects.

Data: Still rely on COMPUSTAT but focus on small firms in four high tech industries. I thought they have some other dataset. Some important descriptive statistics: sample firms are growth firms, they seem to support the smooth behavior R&D view, they don’t rely on debt to finance investment, and they don’t pay dividends. (Internal finance constraints)

Economic Specification and Results:

Within-firm results: A fairly large percentage of the with-in firm variation, particularly for R&D, is explained by within-firm variation in internal finance alone. Elasticity is evaluated at the means in Table 2. The lower estimated elasticity for cash flow for R&D may reflect the smooth R&D investment due to the high adjustment costs. The cash flow is important as a source of finance rather than as a proxy for firms’ investment opportunities.

Between-firm results: Why do the authors use between-firm analysis even though it cannot capture the unobservable heterogeneity? 1) Over 3/4 of the variance of the R&D ratio is in the cross-sectional dimension, and 2) transitory component of cash flow tends to average out over time. The increase in R&D coefficient and the nearly offsetting decline in the physical investment coefficient are consistent with the view that firms smooth R&D at the expense of physical investment.

IV results: R&D is unresponsive to the transitory component in cash flow and therefore both the within and first differenced estimates understate the effects of cash flow on R&D. With-in firm results underestimate the effect of cash flow on R&D but that the between-firm results do not. Physical investment is relative more responsive to transitory movements in cash flow (from comparing estimates with different methods)