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The Financing of R

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Asymmetric information between financier and firm implies there is a lemons premium ... Akerlof (1970): if lemons premium large enough, market disappears ... – PowerPoint PPT presentation

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Title: The Financing of R


1
The Financing of RDPart 1
  • Bronwyn H. Hall
  • UC Berkeley and U of Maastricht

2
Outline
  • Economics of RD as investment
  • Implications for financing RD
  • Asymmetric information
  • Agency costs
  • Evidence
  • Implications for technology policy (limited)

3
Economics of RD and innovation
  • Arrow 1962 market fails to allocate adequate
    resources to innovation because..
  • Lack of full appropriability of returns
  • unpriced positive externalities
  • Indivisibility of output
  • implies market power for innovator from returns
    to scale
  • Financing is costly
  • because of info asymmetry and risk
  • especially when financier and entrepreneur are
    different people

4
RD as investment
  • Similarity
  • Expenditure undertaken today to secure
    (uncertain) returns in the future
  • Differences
  • Composition wages of scientists and engineers
    are more than half of spending
  • Asset created is intangible
  • Unknown share is human capital (partly owned by
    employees)
  • Not easily tradeable (low salvage value)
  • Level of uncertainty much more extreme

5
Implications for policy and practice
  • Production of knowledge is not intemporally
    separable ? adjustment costs high
  • Policy changes take time to have an impact
  • Measurement difficulties - RD does not exhibit
    much variation over time within a firm
  • Responds slowly to changes in capital cost (LHS)
  • Little variation to identify its productivity
    (RHS)
  • Uncertainty in some cases, distribution of
    returns is Pareto (and without a second moment)
  • risk adjustment problematic

6
Modeling RD investment
  • Marginal profit condition marginal product of
    RD capital equals tax-adjusted user cost of
    capital
  • r investors required rate of return
  • d (economic) depreciation rate
  • MAC marginal adjustment cost
  • t corporate tax rate
  • Ad PDV of depreciation allowances
  • At PDV of tax credits
  • Last equality holds if RD expensed and no
    special tax credit.

7
Implications for RD finance
  • Debt versus equity finance
  • debt prefers physical assets as collateral but ..
  • RD creates an intangible asset
  • Tax treatment
  • Tax subsidies to RD in some countries but..
  • Debt sometimes cheaper than equity
  • Depreciation (private obsolescence) highly
    variable and endogenous to other firms behaviors

8
Required rate of return to RD
  • Probably higher than that for ordinary
    investment
  • Uncertainty and risk
  • Asymmetric information between financier and firm
    implies there is a lemons premium
  • Mitigating asym info by revealing idea to
    potential investor is costly and can lead to
    imitation
  • Akerlof (1970) if lemons premium large enough,
    market disappears
  • One solution hands-on venture capital investment
  • Agency costs can arise in any setting where the
    goals of a principal and his/her agent conflict

9
Agency costs for innovative firms
10
Testing for financing constraints due to info
asymmetry (1)
  • Information asymmetry implies internal funds are
    cheaper than external funds
  • Test set up RD investment equation and test for
    excess sensitivity to cash flow shock, as is
    done for investment
  • Models used
  • Accelerator - optimal capital stock proportional
    to output, actual capital takes time to adjust
  • Euler equation - from dynamic program of a
    value-maximizing firm

11
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12
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13
Testing for financial constraints due to info
asymmetry (2)
  • Three empirical methods
  • Stratify firms by cash constraints faced,
    estimate equation for each group and test for
    differences
  • Stratification sometimes debatable (Fazzari et al
    vs Kaplan-Zingales)
  • Include a cash flow measure in the equation to
    proxy for constraints and test for its presence
  • Identification of demand vs supply shocks is an
    issue
  • Euler equation model shadow value of investment
    funds as a function of changes in financial
    position to test whether it varies with them
  • Theory relies on substitution of financing and
    spending in adjacent periods, low power

14
Results of tests
  • Methods applied to large firms in the US, UK,
    France, Germany, Ireland, and Japan
  • Cash flow sensitivity is greater in Anglo-Saxon
    economies (US, UK, Ireland), although some of the
    effect may be a response to demand shocks
  • Low, but not zero, in France, Germany, Japan
  • Greater for smaller firms

15
Testing for agency costs
  • Previous approach will not work firm is assumed
    to maximize something other than value
  • Use marginal condition and add indicators of
    owner-manager separation?
  • Usual method - measure effects of increasing
    managerial security or the managerial share of
    firm
  • Examine differences in investment behavior across
    different ownership classes

16
Do agency costs matter?
  • Managers-owners tests are somewhat weak and
    evidence is unclear (and magnitude unknown)
  • Antitakeover amendments do not reduce and may
    increase RD (US)
  • Institutional ownership associated with higher
    RD (US)
  • Diffusely held firms less innovative (measured by
    RD spending) (US UK)
  • Majority-minority shareholders (Europe)
  • Hall and Oriani RD in majority-controlled
    firms valued less (essentially zero in Italy)
    one manifestation of tunnelling?
  • Munari, Oriani, and Sobrero family-controlled
    firms do less RD

17
Policy implications?
  • General
  • Evidence does not contradict Arrows argument
    that there will be underinvestment without some
    policy attention
  • Small and new firms are more disadvantaged
  • Agency costs exist, but the story is incomplete
    no obvious policy recommendation
  • Gilson
  • creating a VC market requires three players (VC,
    investor, entrepreneurs) and correct incentives
    among them
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