The Impacts of R&D investment and financial constraints on firm value

Abstract

R&D investment has long been identified as a key driver of the long-term economic growth and increased market valuation of firms. Previous studies have shown the positive effect of a firm’s aggressive research activities on productivity and market valuation. Despite R&D's crucial role in firm growth and the importance of sunk costs, comparatively few studies investigate the impact of R&D investment by financially constrained firms. If a financially constrained firm cannot raise sufficient financial resources to perform R&D, there is an increased probability that the firm will fail to complete an R&D project before its competitors do, resulting in a decrease in the value of the failing firm. This paper investigates the relationship between R&D investment and firm value in financially constrained firms. We explore how the R&D investment of such firms affects their market value. We discover that (with the exception of a few extremely constrained groups) the greater a firm’s financial constraints, the greater the positive impact of R&D on firm value. We postulate that the reason for these results is that the managers of financially constrained firms are under more pressure to select positive NPV-value-creating R&D projects than are the managers of financially flexible firms. In addition, our study further examines the effects of competition on this result. We find that the impact of R&D investment increases as competition increases, with the exception of a few highly concentrated industries. Lastly, we analyze this impact in light of firm size. Here, we could not conclude that the larger the financially distressed firm, the greater the effect of R&D investment on firm value. Dividend policy is one of the most important managerial decisions and has been extensively examined in the finance literature. Even though previous studies have suggested that financial constraints have negative effects on the dividend payout policy of firms, recent empirical studies have suggested that financially constrained firms pay dividends to shareholders and that the number of financially constrained firms that pay dividends increases over time. Apparently, financially constrained firms have incentives to use dividends to establish good reputations to reduce future external financing costs. Consistent with the dividend signaling theory, financially constrained firms with R&D could consider dividend payouts an effective method for signaling their decent future prospects to the market. Thus, this paper shows that the effect of R&D on the firm value of financially constrained firms with dividend payout policy is much stronger than financially constrained firms without dividend payout policy. Traditional theories, including the pecking order and residual dividend theories, argued that paying dividends could be quite costly for financially constrained firms, thereby worsening their financial constraints. Nevertheless, recent studies on dividends show that dividend policy of financially constrained firms could be utilized positively to provide positive signal to financial market. In addition to previous researches, we suggest that R&D investment of financially constrained firms with dividend policy have greater and positive impact on their market value than firms without dividends. Managers of financially constrained firms are more likely to use dividend payments to provide positive signals regarding their future R&D performance than are the managers of financially unconstrained firms. We also test whether larger and older firms among financially constrained firms with dividend policy function in a similar manner. R&D investment of constrained firms with greater size, higher age, and dividend policy could be considered by the market as positive signals by mitigating investors’ perspective on the future prospect of the firms, despite the financial constraint of them. Overall, we suggest that dividend policy of R&D firms with financial constraint could be utilized to provide the positive signal to the financial market.