Recent empirical studies show that innovative firms heavily rely on debt financing. This paper develops a Schumpeterian growth model in which firms' dynamic R&D, investment, and financing choices are jointly and endogenously determined. It then investigates the relation between debt financing and innovation and growth. The paper features a rich interaction between firm policies and predicts substantial intra-industry variation in leverage and innovation, consistent with the empirical evidence. It also demonstrates that while debt hampers innovation by incumbents due to debt overhang, it also stimulates entry, thereby fostering innovation and growth at the aggregate level. * We would like to thank Julien Cujean, Luca Mazzone (discussant), Johan Walden, and seminar participants at the SFI Research Days
Recent empirical studies have shown that innovative firms heavily rely on debt financing. Debt overhang implies that debt hampers innovation by incumbents. A second effect of debt is that it stimulates innovation by entrants. Using a Schumpeterian growth model with endogenous R&D and financing choices, we demonstrate that this second effect always dominates, so that debt fosters innovation and growth at the aggregate level. Our analysis suggests that the relation between debt and investment is more complex than previously acknowledged and highlights potential limitations of empirical work that solely focuses on incumbents when measuring the effects of debt on investment.
Corporate finance has related corporate policies to cash flow risk. I show that corporate valuation and policies are better understood when taking into account the dynamics of products, which microfound firms' cash flows. I demonstrate empirically that product portfolio age is negatively related to firm value, investment and leverage, consistent with the product life cycle channel. I quantify its importance by estimating a model of financing, investment, and product portfolio decisions. The model rationalizes the stylized facts by showing that capital investment and product introductions act as complements and that product dynamics induce stronger precautionary savings motives. The results indicate that product dynamics are important, as they explain 25% of variation in investment and leverage. The estimates imply that product life cycle effects are large and stronger among firms supplying fewer products and competing more intensely. Alleviating these effects can increase firm value by up to 4.5%.JEL Classification: G31, G32.I document that product portfolio age has a sizeable effect on firms' profitability, implying that product life cycle effects translate to the product portfolio level. Crucially, the effect of product portfolio age on revenue is markedly different from that of firm age. I also show that the product life cycle channel results in a negative relationship between the market-to-book ratio and product portfolio age. This result implies that managing product portfolios has direct implications for firm value. Thus, product decisions of value-maximizing firms should be reflected in their investment and financing choices: empirically, both net leverage and capital investment are also negatively related to product portfolio age.I rationalize these empirical patterns by developing and estimating a dynamic model of the firm which makes investment, financing and product decisions. In the model, the firm combines capital and products to generate revenue. It finances its activities with current cash flow, net debt subject to a collateral constraint, and costly external equity. Importantly, consistent with the product life cycle channel, each product follows a life-cycle pattern: new products provide higher revenue than old ones and are expected to last longer, because old products can exit. When deciding on introducing a new product to its portfolio, the firm trades off the benefits, associated with higher and more durable revenue of a younger product portfolio, versus a fixed introduction cost. The fact that the firm can adjust the product portfolio's composition has direct implications for cash flow dynamics, and thus connects the firm's real, financial, and product decisions. 2The model provides economic rationale to the empirical stylized facts. First, it shows that capital investment and product introductions are complements rather than substitutes, indicating that the firm expands its product lines while also investing in production capacity.The firm increases capital investment when introducing new pr...
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