Internal Finance and R&D in Small High-Tech Firms: A Panel Study
R&D and Internal Finance: A Panel Study of Small Firms in High-Tech Industries
Himmerlberg and Petersen (1994)
Introduction
Since Schumpeter, economists have argued that internal finance is an important determinant of R&D investment. However, previous empirical studies have largely failed to find evidence of such a relationship. This study investigates the relationship using new panel data on small firms in high-tech industries. The pecking order theory supports this relationship: moral hazard and adverse selection in debt and equity markets make internal capital valuable.
External Validity
Acs and Audretsch (1988) show that small firms account for a major fraction of new innovations in US manufacturing. This study focuses on small firms in high-tech industries, which may have strong internal validity, but its external validity is questionable.
Why Examine Physical Investment?
The authors also examine the effect of internal finance on physical investment for three reasons:
- To compare their findings to existing literature on physical investment under capital market imperfection.
- It is inappropriate to strictly divide R&D and physical investment.
- New knowledge must be embodied in the production process through investment in new plant and equipment.
Main Findings
Controlling for unobservable firm effects, they find a large and statistically significant relationship between both R&D and physical investment and internal finance. Within-firm estimates are downward biased if firms smooth R&D in response to transitory shocks in cash flow. Using an instrumental variable (IV) approach, they find elasticities for R&D and physical investment are 0.067 and 0.822, respectively.
Empirical Issues in Previous Studies
Previous R&D and internal financing literature focused on large firms, which tend to generate more cash flow than needed for investment. In internal financing and physical investment literature, researchers find a statistically significant explanatory role of internal resources in explaining variations in physical investment.
Pecking Order Theory
The pecking order theory is based on information asymmetry between firms and external finance providers. Small and high-tech firms face this issue. Moral hazard problems are highly relevant for R&D projects since the output cannot be perfectly predicted from the inputs. Unmonitored borrowers may use loans for projects 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 growth rate is constrained by access to internal finance. Firms expand as rapidly as their internal finance permits. The production function includes both a stock of capital and a stock of technology. Output is a homothetic function of technology and physical capital, and the stock of technology is acquired through R&D investment.
Financial Constraints
The authors assume that small, high-tech firms face a binding financial constraint on investment expenditures. This leads to high information asymmetry, making internal finance valuable for investment.
Cash Flow Coefficients
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 the time period covered by their panel.
Adjustment Costs
A large fraction of R&D is payment to high-skilled workers, such as researchers and engineers, who cannot be easily fired and replaced. High adjustment costs bias the results.
Minimizing Adjustment Costs
To minimize current and future adjustment costs, firms set R&D investment according to the permanent level of internal finance. If a firm believes a shock to internal funds is transitory, it attempts to maintain planned R&D by adjusting physical investment or working capital. The authors decompose current cash flow into permanent and transitory components.
Predictions
If R&D and physical investment were the only components of total investment, the cash flow coefficients would sum to one. However, in reality, the coefficients should sum to a number that is large but less than one. If adjustment costs are important, R&D may not respond equally to transitory and permanent cash flow shocks. The conventional within-firm estimator does not capture the difference between permanent and transitory shocks, thus underestimating the effect. Using IV is better to control this bias and allows for individual firm effects.
Data
The study uses COMPUSTAT data, focusing on small firms in four high-tech industries. Sample firms are growth firms, support the smooth R&D view, do not rely on debt to finance investment, and do not pay dividends, indicating internal finance constraints.
Economic Specification and Results
Within-Firm Results
A large percentage of within-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 high adjustment costs. Cash flow is important as a source of finance rather than as a proxy for firms’ investment opportunities.
Between-Firm Results
The authors use between-firm analysis because over 3/4 of the variance of the R&D ratio is in the cross-sectional dimension, and the transitory component of cash flow tends to average out over time. The increase in the 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. Both within and first-differenced estimates understate the effects of cash flow on R&D. Within-firm results underestimate the effect of cash flow on R&D, but between-firm results do not. Physical investment is relatively more responsive to transitory movements in cash flow.