Creditor Rights and R&D Expenditures. Bruce Seifert a Old Dominion University. Halit Gonenc b University of Groningen

Transcription

1 Creditor Rights and R&D Expenditures Bruce Seifert a Old Dominion University Halit Gonenc b University of Groningen a Contact author, Department of Business Administration, College of Business and Public Administration, Old Dominion University, Norfolk, Va , Telephone: (757) , Fax: (757) , bseifert@odu.edu b Department of Finance, Centre for International Banking, Insurance and Finance, Faculty of Business and Economics, University of Groningen, P.O. Box 800, 9700 AV Groningen, NL Telephone: +31 (0) , Fax: +31 (0) , h.gonenc@rug.nl

2 Creditor Rights and R&D Expenditures Abstract This study examines the impact of creditor rights on R&D. We argue that managers in countries with strong creditor rights have more incentives to reduce risk and therefore limit expenditures on R&D more than managers located in countries with weak creditor rights. We analyze this hypothesis using a two-equation system (R&D and the equity ratio being endogenous) for over 10,000 firms in 47 countries. We find that across many samples (developed and developing countries and market and bank-based countries) that strong creditor rights are associated with reduced R&D. Our paper documents that most of the determinants of R&D are the same across all of our samples. In particular, patent rights have a strong positive influence on R&D, not only in developed countries but also in developing countries. Moreover, our findings suggest that the determinants of a firm s financial structure are similar across different levels of development as well as financial systems with one major exception; in bank-based countries, unlike marketbased ones, there is no positive link between R&D and equity financing. JEL Classification: G31; G32; G15 Keywords: Creditor rights; R&D; international financial markets. 2

3 1. Introduction When firms are in financial distress, managers often lose some of their powers. When covenants are violated in debt agreements, managers often face restrictions on investments, dividends, and financing options. In cases of bankruptcy, managers can face more restrictions including the possibility of dismissal. Clearly, managers do not want to be in financial distress or in bankruptcy and will try to prevent these possibilities. Managers who fear that financial distress is a possibility may undertake actions designed to reduce risk such as diversifying operations, employing less debt, and reducing capital expenditures. Strong creditor rights may make managers lives worse during these times. Managers may discover that under strong creditor rights their decision-making powers are reduced more and the possibility of losing their jobs is worse than under weak creditor rights. Under these circumstances, it would seem reasonable that managers might try more risk reducing activities under strong creditor rights than under weak creditor rights. Recent studies (Acharya et al., 2009 and Acharya and Subramanian, 2009) indicate that managers in firms located in countries with strong creditor rights do, in fact, engage in more diversifying acquisitions, which result in poor performance, have lower cash flow risk, lower leverage, and reduce innovations. Other studies show that creditors significantly influence capital structure (Roberts and Sufi, 2009), investment policies (Nini et al., 2009), and dividend policies (Brockman and Unlu, 2009). Our paper focuses on another avenue managers might take to reduce risk which is to limit R&D expenditures. R&D in most cases is a risk-increasing activity. The returns to R&D range from negative to a huge payoff. We examine whether investments in R&D are, on average, 3

4 greater in countries with weak creditor rights than in countries with strong creditor rights. As far as we know, our paper is the first to examine this linkage. R&D is an extremely important part of any economy. Successful R&D leads to new or better products and cheaper ways to manufacture them. If R&D is reduced in response to stronger creditor rights it may result in some very unwanted consequences. Our paper tries to document the relationship between creditor rights and R&D. We leave it to others to examine whether strong creditor rights cause firms to move away from optimal levels of R&D. We investigate the relationship between creditor rights and R&D using data for more than 10,000 firms from 47 countries. To account for the fact that R&D and debt are likely jointly determined, our empirical procedure treats both R&D and the debt ratio as endogenous. Our analysis also specifically incorporates the impact of intellectual property rights on R&D decisions. Our regressions and correlation analysis suggest that strong creditor rights decrease R&D intensity (R&D/total assets) across all of our samples (developed and developing countries as well as market and bank-based countries). In market-based and developed countries only, the negative impact of creditor rights on R&D is worse for firms that have negative cash flows, our proxy for financial distress. Our results are consistent with the view that managers worry more about the negative consequences of financial distress (for themselves and their company) in countries that have strong creditor rights than in countries with weak creditor rights. As a result, firms reduce risk more in countries with strong creditor rights. One of these risk-reducing strategies is the reduction of R&D. Another important finding of our research is that determinants of R&D are largely invariant across our samples. In addition to the negative impact of creditor rights on R&D, we 4

5 find that patent rights, market-to-book ratios, equity ratios, and cash flows all have a positive impact on R&D. The influence of cash flows on R&D depend on whether cash flows are positive (a positive impact on R&D) or negative (a negative impact). In addition, the determinants of the leverage equation (in our case the equity ratio) are basically the same across our samples. Cash flow and market-to-book ratios both have a positive effect on the firm s use of equity, while size and a measure of adverse selection tend to reduce the amount of equity employed by firms. We do not find that higher levels of R&D are associated with greater uses of equity financing in bank-based countries. We find just the opposite for market-based countries. The rest of the paper is as follows. In section 2, we briefly review some pertinent literature and in section 3, we describe the data, our hypotheses, and our methodology. Our findings are presented in section 4 and conclusions are given in section Pertinent literature 2.1 R&D investment and financing of R&D A number of authors (for example, Bhagat and Welch, 1995) have argued that R&D can be viewed as an investment for a firm. There are, however, differences between these expenditures and other investments. As Hall (2002) points out, 50% or more of the expenditures for R&D can be tied up in salaries and wages of scientists and engineers. Since the knowledge base of these key individuals can be lost if these people are fired or leave the firm, R&D expenditures should remain fairly constant year to year. Another difference between R&D and other investments is that there is a high degree of uncertainty (outcomes) associated with these expenditures. As Hall argues, there is a small probability of great success attached to R&D expenditures. 5

6 A problem that is likely worse for R&D than for other investments is the information asymmetric issue. Scientists and engineers (and insiders) have more information than investors do, and firm insiders do not want to reveal this information to outsiders (especially their competitors) to solve this problem (Bhattacharya and Ritter, 1983). Bhagat and Welch (1995) and Bah and Dumontier (2001) argue that this can explain the use of internally generated funds to support R&D. Hall (1992) and Himmelberg and Petersen (1994) find that there is a positive relationship between R&D and cash flow 1 for US firms. Brown and Peterson (2009) show that the relationship between R&D and cash flow is still strong, unlike the relationship between physical investment and cash flow that has decreased over the years. Brown et al. (2009) observe a significant relationship between cash flow (and also external equity) and R&D for young hightech companies, but not for mature high-tech firms. Research has shown that stronger intellectual property rights leads to more R&D (see, for example, Wu (2009) for OECD countries and Lin et al. (2009) for evidence from China). Firms should conduct more R&D if they feel there is less chance that their R&D efforts will be stolen or imitated. It has also been argued that debt should not be used to finance R&D. In most cases R&D do not have much liquidation value in the event of bankruptcy. In addition, firms with high R&D expenditures probably reflect high growth opportunities and hence suffer from the underinvestment problem (Myers, 1977) and thus equity is probably better suited to finance R&D. Bhagat and Welch (1995) show that there is negative relation between last year s debt ratio for US firms and this year s R&D expenditures. However, they found that this same 1 See also Harhoff (1998) for German firms, Bond et al. (1999) for UK and German firms and Mulkay et al. (2001) for French and US manufacturing firms. 6

7 relation was positive for Japanese firms and no significant relation was found for Canadian, British, and European (Germany, France, and Netherlands) firms. Friend and Lang (1988) and Hall (1992) also find a negative relationship for US firms between leverage and R&D expenditures. Bah and Dumontier (2001) find that R&D intensive firms have lower leverage levels than non-intensive R&D for firms in the US, UK, Japan, and Europe. In summary, prior literature suggests that R&D should be positively related to intellectual property rights and cash flow. Research has also shown the importance of equity financing for R&D. 2.2 Shareholder and creditor rights There are a number of studies that have documented the effect of shareholder and creditor rights on different corporate policies. La Porta et al. (2000) show that investors from countries that have strong minority shareholder rights obtain higher dividends than investors residing in countries that have low minority shareholder rights. These authors argue that their results support the outcome model where minority stockholders are able to extract dividends by using their legal powers (more rights lead to more dividends). The alternative model suggested by La Porta et al. is the substitution model where firms pay dividends now in order to be able to raise additional capital in the future. In this model, it is the firms residing in countries with poor minority stockholder rights that need to pay dividends in order to build a reputation of being fair to these shareholders. Shareholder rights have also been found to influence investment policies (Love, 2003) and ownership policies (La Porta et al., 1998 and 1999). More recently, Brockman and Unlu (2009) show that creditors influence dividend payouts significantly. In this case, creditors demand and managers agree to pay fewer dividends 7

8 when creditor rights are weak. Their results are consistent with a substitution model (less dividends substitute for weak creditor rights). Nini et al. (2009) also demonstrate the power of creditors and their ability to influence investment policy. These authors find that 32% of private credit agreements between banks and firms have a capital expenditure restriction 2. The authors show that these restrictions are effective in reducing firm investment. Roberts and Sufi (2009) find that creditors have a significant effect on capital structure. Issues of net debt decrease after debt covenant violations causing changes in capital structure. It should be noted that more than 25% of the firms in their sample experienced a violation in their covenants. Acharya et al. (2009) observe that firms in countries with strong creditor rights are more likely to engage in harmful diversifying mergers, have lower cash flow risk, and lower leverage, than companies in countries with weak creditor rights. Acharya and Subramanian (2009) find that firms in countries with strong creditor rights reduce innovation measured in terms of patents and citations. In summary, the results of many prior studies indicate that shareholder rights and creditor rights can and do influence corporate policies. Our research examines whether creditor rights in particular, similarly affect expenditures on R&D Hypotheses, methodology, and data 3.1 Hypotheses Our principle hypothesis is that firms located in countries with strong creditor rights will conduct less R&D. Many managers are scared of the consequences of financial distress and will do their best to avoid it. We argue that strong creditor rights will increase the negative 2 Prior studies using bond covenants, as opposed to private credit agreements, did not find very many restrictions on investments (see Smith and Warner, 1979 and Billett et al., 2007). 3 Our research in some ways resembles Acharya et al. (2009). They are concerned with output measures of R&D while we focus on input measures (expenditures on R&D). 8

9 consequences of financial distress to managers (loss of decision-making and increased possibility of job loss). Managers will probably increase their efforts to avoid financial distress and therefore will reduce R&D more under strong creditor rights than under weak creditor rights. We also expect that the negative effects of creditor rights on R&D will be stronger for firms that are in financial distress or close to financial distress. We proxy financial distress or close to financial distress as firms with cash flows that are on average negative. Our hypotheses concerning creditor rights and R&D should hold in market-based countries. Whether this relationship holds in bank-based countries is an empirical question. Banks in bank-based countries may act to reduce R&D in general and it may not matter whether the particular country has strong or weak creditor rights. 3.2 Methodology We investigate our hypotheses using the following two-equation system. R&D = b 0 + b 1 Eq.R + b 2 CF + b 3 MB + b 4 CR + b 5 IPR + b 6 HTD + e 4 (1) Eq.R = c 0 + c 1 R&D + c 2 CF + c 3 MB + c 4 CR + c 5 AS + c 6 Sz + u (2) Where R&D = Research and Development and equals (R&D expenditures / book value of total assets). Eq.R = Equity ratio and equals (total equity / book value of total assets). CF = Cash Flow and equals [(Net income + Depreciation + R&D expenditures) / book value of total assets]. 4 In an earlier version of this paper, we included shareholder rights in the R&D equation. Our findings were generally supportive of the idea that increased shareholder rights resulted in more R&D. However, after including intellectual property rights in the equation the relationship between shareholder rights and R&D became very inconsistent. In the original version we used four estimates for shareholder rights and all showed a positive country correlation with our measure of creditor rights (ranging between 0.16 and 0.44). Two of the four estimates were significant. The correlation between shareholder rights and intellectual property rights is positive but insignificant. 9

10 MB = Market to Book Ratio and equals [(the market value of equity +book value of debt) / book value of total assets]. CR = Creditor Rights and equals the score from Djankov s et al. (2007), IPR = Intellectual Property Rights and is equal to the patent rights index for 1985 from Ginarte and Park (1997) and Park (2008). HTD = High Tech Industries Dummy and is equal to 1 if the firm is in the following SIC codes 283 (drugs), 357 (office and computing equipment), 366 (communications equipment), 367 (electronic equipment), 382 (scientific instruments), 384 (medical instruments) and 737 (software) and 0 otherwise. Sz = Size and is measured as the logarithm of total assets in US dollars. AS = Adverse Selection and is the standard deviation of monthly excess returns (firm stock return local market return). We use a two-equation system because it is likely that both R&D and debt policy (equity ratio, Eq.R) are endogenous. The firm probably makes both decisions jointly and, furthermore, the decision of one likely influences the other decision. As was previously discussed, R&D intensity should have a negative influence on leverage. Firms for many reasons prefer to fund R&D mostly with equity. On the other hand, Jensen and Showalter (2004) present a model where the amount of leverage affects total R&D expenditures. In a patent race these authors show that debt reduces the amount of R&D expenditures. As a result, we use two-stage least squares to estimate the coefficients for equations 1-2. For the R&D equation, greater use of equity should lead to higher amounts of R&D. Firms residing in countries with greater intellectual property rights should conduct more R&D since the fruits of their labor are more likely to remain within the firm (not get stolen or illegally 10

11 imitated). Assuming that external funds are more expensive than internal funds, greater cash flows should lead, on the margin, to more R&D. Higher market-to-book ratios should indicate more investment opportunities and this should be associated with more R&D. To account for the fact that certain industries historically do a lot of R&D, we use a dummy variable that equals one for firms in those industries. In the hypothesis section, we argue that greater creditor rights should result in less R&D 5. Our R&D equation has the direction of causation from more intellectual property rights to more R&D. One could argue that as firms and countries do more R&D they might want more protection of their new inventions. However, Kanwar and Evenson (2009) and Wu (2009) find that the link running from R&D to property rights is weak or non-existent. In addition, we use the property rights index at the beginning of our data period to reduce possible endogeneity issues. For the Eq.R equation, we include many of the traditional leverage variables used in prior studies (see, for example, Rajan and Zingales, 1995). Since we are using the equity ratio instead of the leverage ratio, the signs for the coefficients on the independent variables should be just the opposite of the leverage ratio. The R&D variable can be thought of as the ratio of an intangible asset to total assets and should have, as discussed above, a positive influence on the equity ratio. Greater cash flow (CF), all other things being equal, should lead to a lower need for debt and hence have a positive influence on the equity ratio (Eq.R). High market-to-book ratios (MB) can indicate increased investment opportunities, which are associated with increased use of equity. Larger size (Sz) can result in more diversified cash flows and less bankruptcy risk and hence 5 It might be argued that education is another variable that should be included in this equation. Firms residing in countries with greater education would be expected to perform more R&D. However, the correlation between education (the average schooling in years in the population over 25 years old in 1990, source Barro and Lee, 1996) and property rights is very high. The country correlation is.72 and at the firm level it is

12 more debt financing or less equity financing. Finally, we include a measure of adverse selection (AS). All things being equal, greater amounts of information asymmetry should lead to less use of equity. The effect of creditor rights (CR) on the equity ratio is ambiguous. On one hand, stronger creditor rights should result in more people and institutions willing to lend money to firms due to the increased chance of getting their investment returned and hence leverage would increase. Djankov et al. (2007) report an increase in the supply of credit due to stronger creditor rights. On the other hand, firms may decrease the demand for credit because of stronger creditor rights. Acharya et al. (2009) finds that leverage is reduced as a result of stronger creditor rights (firms are trying to reduce their bankruptcy risk). All of our variables for a particular firm are averaged over time. In other words, for each firm we average all available observations to get the mean of R&D, MB, etc. The sample size is then simply the number of firms. We follow this approach because as Hall (2002) argues R&D is sticky. It does not change much from year to year. There is a large volume of literature on the investment-cash flow sensitivity. Our purpose here is not to review that literature but highlight one important fact from that literature that appears relevant to our study. Allayannis and Mozumdar (2004) argue and then empirically show that negative cash flows observations can help explain the different results of Fazzari et al. (1988) with those of Kaplan and Zingales (1977) and Cleary (1999). Allayannis and Mozumdar believe that firms with severe cash flow problems have already cutback investments to the minimum, further cash flow problems will not elicit further reductions in investments, and hence the sensitivity of investment to cash flow is weak. Because R&D may respond to cash flow differently depending on the level of cash flow, we perform our regressions on all of our 12

13 observations first and then repeat these regressions using just those observations that have positive cash flows. 3.3 Data Our financial data is gathered from Worldscope from 1980 to 2006 for 47 countries. We exclude financial firms and utilities and thus avoid any regulatory influences. Data from Worldscope does contain some errors and thus we winsorize the data. The top and bottom 1 percent of all of our financial variables are set equal to the values for the 99 and 1 percent level respectively for those variables. Hence, extreme outliers are eliminated. We examine all firms that indicate that they perform R&D. In other words, they have at least one year where they report a positive value of R&D. For creditor rights we use the index by Djankov et al. (2007) that determines the powers of secured lenders during bankruptcy for the year Countries are scored according to four attributes 6. One of the criteria is whether an administrator and not management is in charge of the company during reorganization. The index has been very stable over the period A number of studies have shown that patent protection is a good indicator of intellectual property rights (see, for example, Marron and Steel, 2000 and Ostergard, 2000) and thus we use the patent protection index of Ginarte and Park (1997) and Park (2008). This index considers five areas: (1) extent of coverage, (2) membership in international patent agreements, (3) provisions for loss of protection, (4) enforcement mechanisms, and (5) duration of protection (Ginarte and Park (1997), page 284) 7. In unreported results, we find that the correlations between intellectual 6 See Djankov et al. (2007) page 302 for a description of these four factors. 7 Kanwar and Evenson (2009) make the point that the agreement on Trade Related Intellectual Property issues in 1994 brought countries policies on property issues closer together but there are still substantial differences between countries. 13

14 property rights indices over five year intervals are very high indicating that there is a lot of stability over time in the index. Table 1 gives descriptive statistics for our main variables. For all firms conducting R&D, the median (mean) ratio of R&D to total assets is (0.071). The mean (median) of Eq.R for companies in our sample is (0.536), which indicates that, on average, firms use a little more equity than debt. Firms in our sample, generally, have a positive cash flow. It should be recalled that our measure of cash flow is net income plus depreciation plus R&D all divided by total assets which should give a little higher number than the more traditional measure of net income plus depreciation all divided by total assets. The IPR index in our sample has a low of 0.59 (Peru) and a high of 4.68 (United States). The average is Creditor rights range from 0 to 4 with an average of Table 1 also compares our key variables between developed and developing countries. As expected, developed countries do much more R&D (0.085 vs ) and have higher scores on patent protection (3.34 vs. 1.74). They do not have, on average, significantly higher scores on creditor rights (2.14 vs. 2.0) 8. [Please insert Table 1 about here] 4. Results 4.1 Correlation results Panel A of Table 2 presents the country correlation coefficient between CR and IPR. The relationship is positive but insignificant. Panels B and C of Table 2 give the correlation 8 Also included in Table 1 are comparisons between market and bank-based countries. In addition, since this sample is heavily weighted toward U.S. firms we provide comparisons between (1) developed countries excluding the US observations and developing countries and (2) market based-countries excluding the US observations with bankbased countries. 14

15 coefficients for the firm level variables used in the regressions. The difference between the two panels is that all observations are used in Panel B while only observations that have positive cash flows are used in Panel C. Both Panels B and C show that CR is significantly negatively related to R&D, and IPR has a significant positive association with R&D. Panel B shows that R&D is positively related to Eq.R, HTD, and MB and negatively related to CF and Sz. All of these relationships are as expected except for CF. In Panel C the relationship is positive between CF and R&D. This suggests that it is the negative cash flow observations in Panel B that are causing the negative correlation between CF and R&D in Panel B. Both panels B and C show that Eq.R is positively associated with MB and AS, our measure of adverse selection and negatively related to Sz. The positive association between Eq.R and AS was unexpected. CF is negatively related to Eq.R in Panel B but positively related in Panel C, the same phenomena we observed for CF and R&D. [Please insert Table 2 about here] 4.2 Regression results We present our basic regression results in Tables 3-5. Table 3 reports the results for all countries (Panel A) and for all countries minus the US (Panel B). Table 4 gives similar results for developed (Panel A) and developing countries (Panel B) while Table 5 presents the findings for market-based (Panel A) and bank-based countries (Panel B). For each of the six different groups, we report the findings for three sets of results (each set contains the findings for both the R&D equation and the Eq.R equation). The first two sets report findings using all observations for that group while the third uses only the positive cash flows for that group. Focusing on the positive 15

16 only cash flow samples allows us to examine the determinants of both R&D and Eq.R after we eliminate unhealthy firms (all the remaining firms have on average positive cash flows). The first set of results use the variables in equations 1 and 2. The second set replaces the cash flow variable with a dummy variable (NegCF) that equals one if the firm s cash flows on average are negative and zero otherwise. We also add an interactive term (NegCF*CR). The interactive term allows us to examine the impact of CR on R&D when the firm is in financial distress or near financial distress 9. Before presenting our regression results, we note that tests for endogeneity (see Wooldridge, 2000) show that the equity ratio is endogenous in the R&D equation, while R&D is endogenous in the Eq.R equation. These results suggest that a two-equation system is appropriate All countries and all countries minus the US R&D equation Our main result in Table 3 is that strong creditor rights acts to reduce R&D intensity. The coefficient for CR is strongly significant no matter whether we look at the first set of equations in Panels A and B or just the positive only observations for those two panels. The coefficient for the interaction term (NegCR*CR) in both Panels A and B indicates that the negative effect of creditor rights on R&D is more pronounced for those firms that either suffer from financial distress or are near financial distress. With the exception of the variable CF, the coefficients for the equity ratio, Eq.R, marketto-book ratio, MB, patent rights, IPR, and high-tech industries, HTD, are very consistent across 9 In this case, the coefficient on CR term represents the impact of creditor rights on R&D when the firm s average cash flows are positive. The impact of CR on R&D when the firm s average cash flows are negative is the sum of the coefficients on CR term plus the interaction term (NegCF*CR). 16

17 all of the specifications in Panels A and B and all have the expected signs. The coefficient for Eq.R is positive and indicates that a greater use of equity is associated with more R&D. This result is consistent with Jensen and Showalter s (2004) conjecture. Firms residing in countries with strong patent rights (IPR) perform more R&D. More investment opportunities (MB) result in more R&D. The coefficient is positive for firms that belong to industries (HTD) that historically perform more R&D. The one variable that does not have a consistent sign for the R&D equation is CF. It has a negative sign when all observations are used but a positive one when just positive cash flow observations are used (the same results we found in the correlation analysis). This finding highlights the fact that the negative cash flow observations behave differently than the positive cash flow observations, a result that resembles the findings for investment in general by Allayannis and Mozumdar (2004). In the normal case (positive cash flows), increased cash flow results in more R&D. This is consistent with the notion that internal funds are cheaper than external funds. Equity Ratio equation The coefficients (with the possible exception of CR) for the Eq.R equation all have the expected signs in Panels A and B 10. Higher R&D intensity reduces the amount of debt. This result is in line with many researchers who have argued that debt should not be used, in general, to fund R&D. Higher cash flows lead to a higher equity ratio. This result is consistent with many studies that show higher profitability results in lower debt ratios. Bigger firms use relatively more debt, presumably because their cash flows are more diversified and thus suffer less 10 With so many equations and so many variables there are bound to be a few exceptions. If a particular coefficient is significant in all specifications but one (we present six R&D equations and six equity ratio equations) in Table 3, we report and concentrate on the findings for the five equations. If there is more than one exception then we generally report our results as inconclusive. We follow the same procedure for Tables 4 and 5. 17

18 bankruptcy risk. Our proxy for adverse selection suggests that firms with greater amounts of adverse selection have lower equity ratios, which is consistent with the idea that greater adverse selection costs increase the cost of equity. The creditor rights variable, CR, has a significant positive coefficient in a couple of cases but generally an insignificant impact on the leverage results. As discussed earlier, the expected sign for this variable is ambiguous and researchers have found different results. Roughly forty percent of our sample is US observations and we address whether the relationships we find for the entire sample also holds for the sample of non-us countries. For both the R&D equation and for the Eq.R equation none of the coefficients change sign or lose their significance as a result of eliminating the US firms. 11 In short, the US firms are not driving our findings. [Please insert Table 3 about here] Developed vs. developing countries R&D equation Our findings in Table 4 show that the determinants of R&D are similar between developed (Panel A) and developing (Panel B) countries with the exception of creditor rights, CR. The signs and significance of the coefficients are also quite similar to the ones found in Table 3. In particular in both Panels A and B, Eq.R, MB, IPR, and being a member of a high tech industry, HTD, all have the expected positive impact on R&D. The effect of CF on R&D depends on whether all observations are used or just positive cash flows, the same phenomena we found earlier in table We regard the impact of creditor rights as insignificant on the equity ratio in Panel A because not all of the coefficients are significantly positive. 18

19 The effect of CR on R&D is different between developed and developing countries. For developed countries, the overall effect of CR is negative when all observations are used. However, CR affects R&D negatively only when cash flows are negative (the coefficient on CR is insignificant while the coefficient on NegCF*CR is significantly negative). Interestingly, in developing countries, the overall effect of CR is negative and there is no significant differential between positive and negative cash flows (NegCF*CR is insignificant). Managers in developing countries appear to worry about strong creditor rights regardless of whether they suffer from financial distress or not. Stronger creditor rights result in less R&D in these countries Equity Ratio equation The impact of R&D (positive), Sz (negative) and AS (negative) on Eq.R is the same for both developed and developing countries. The variable CF has the expected sign (positive) in all but one case (the positive only cash flow sample in Panel A). MB is not consistent in either panel. In addition, it has an unexpected sign twice in Panel A. Strong creditor rights in developing countries results in greater usage of equity while it has an insignificant effect in developed countries. [Please insert Table 4 about here] Market-based vs. bank-based countries R&D equation Table 5 reports the results for the comparison of market and bank-based countries. The signs and significance of Eq.R, MB, IPR, and HTD are the same for market-based countries (Panel A) and bank-based countries (Panel B). CF shows a similar pattern to the other samples, 19

20 which is generally negative for all observations and positive for the positive cash flow only sample 12. The impact of CR is negative for both bank-based and market-based countries when all observations are used. Our finding for the interaction variable, NegCF*CR, suggests that it is the firms in financial distress in market-based countries that cause the negative relationship between strong creditor rights and R&D. In contrast, in bank-based countries both strong and weak companies show a negative relationship between CR and R&D. Equity Ratio equation There are two noticeable differences between bank-based and market-based countries in regards to our financing equation, Eq.R. In market-based countries, increased R&D is associated with greater uses of equity while that relationship does not appear to hold in bank-based countries. Perhaps banks in bank-based countries are equally comfortable in supplying funds for R&D as for other types of expenditures. Banks may be quite comfortable with their monitoring efforts in regards to R&D in these countries. The second difference between market-based and bank-based countries regards the impact of the market-to-book ratio. In bank-based countries, higher MB ratios lead to greater uses of equity while the relationship is not stable in market-based countries. The other variables in the Eq.R equation show only little differences between marketbased countries and bank-based countries. [Please insert Table 5 about here] 5. Conclusions 12 The coefficient for bank based countries for cash flow is insignificant when all the observations are used. 20

21 Previous papers have documented that managers often undertake risk-reducing activities when faced with strong creditor rights. These actions include diversifying acquisitions, lower cash flow risk, and lower leverage. Our paper investigates the impact of creditor rights on another corporate decision, namely R&D. We hypothesize that firms residing in countries with strong creditor rights will have lower levels of R&D. We test this hypothesis for firms in 47 countries and use a two-equation framework with both R&D and the equity ratio as endogenous variables. Our results are supportive of our main hypotheses. Creditor rights are associated with reduced levels of R&D in all of our samples. In developed as well as market-based countries, the impact of creditor rights on R&D is mostly found in firms with negative cash flows. Presumably, these firms are currently experiencing financial distress and their managers worry that their firms may soon face bankruptcy. As a result, these mangers undertake activities to reduce risk including limiting R&D. In bank-based and developing countries, we see that strong and weak firms reduce R&D under strong creditor rights. Our results are very important because R&D is critical to many countries. Any unnecessary or unintended decrease in R&D can have major impacts for these countries. We also observe that the determinants of R&D are mostly the same for countries at different levels of development or for countries with different economic systems (bank or market-based). We find that patent rights, market-to-book ratios, and equity ratios, all have a positive impact on R&D. The influence of cash flows on R&D depend on whether cash flows are positive (a positive impact on R&D) or negative (a negative impact on R&D). Creditor rights have a negative impact. 21

22 The determinants of the equity ratio are also similar across our samples. Cash flow and market-to-book ratios both have a positive effect on the firm s use of equity, while size and a measure of adverse selection tend to reduce the amount of equity employed by firms. The one exception to this pattern is the influence of R&D on the equity ratio. In market-based countries, the influence is positive, as expected. In bank-based countries, the impact is not positive. Since banks do a lot of the monitoring in these countries, they may be satisfied with their efforts and thus feel very comfortable in lending for R&D. 22

23 References Acharya, V., Amihud, Y., Litov, L., Creditor rights and corporate risk-taking. NBER Working paper Acharya, V., Subramanain, V., Bankruptcy Codes and Innovation, Review of Financial Studies, 22, Allayannis, G., Mozumdar, A., The impact of negative cash flow and influential observations on investment-cash flow sensitivity estimates. Journal of Banking & Finance 28, Bah, R., Dumontier, P., R&D intensity and corporate financial policy: some international evidence. Journal of Business Finance & Accounting 28, Barro, R., Lee, J.W., International measures of schooling years and schooling quality. American Economic Review Papers and Proceedings 86, Bhagat, S., Welch, I., Corporate research and development investments: international comparisons. Journal of Accounting and Economics 19, Bhattacharya, S., Ritter, J.R., Innovation and communication: signaling with partial disclosure. Review of Economic Studies 50, Billett, M., King, D., Mauer, D., The effect of growth opportunities on the joint choice of leverage, maturity and covenants. Journal of Finance 62, Bond, S., Harhoff, D., Van Reenen, J., Investments, R&D, and financial constraints in Britain and Germany. London Institute of Fiscal Studies Working Paper. Brown, J., Fazzari, S. M., Petersen, B.C., Financing innovation and growth: cash flow, external equity and the 1990s R&D boom. Journal of Finance 64, Brown, J., Peterson, B., Why has the investment-cash flow sensitivity declined so sharply? Rising R&D and equity market developments. Journal of Banking and Finance 33, Brockman, P., Unlu, E., Dividend policy, creditor rights, and the agency costs of debt. Journal of Financial Economics 92, Cleary, S., The relationship between firm investment and financial status. Journal of Finance 54, Demirguc-Kunt, A., Levine, R., Financial structures across countries: stylized facts. In: Demirguc-Kunt, A., Levine, R. (Eds.), Financial Structure and Economic Growth. MIT Press, Cambridge, MA,

24 Demirguc-Kunt, A., Maksimovic, V Funding growth in bank-based and market-based financial systems: evidence from firm-level data. Journal of Financial Economics 65, Djankov, S., McLiesh, C., Shleifer, A., Private credit in 129 countries. Journal of Financial Economics 84, Fazzari, S., Hubbard, G., Petersen, B., Financing constraints and corporate investment. Brookings Papers in Economic Activity, Friend, I., Lang, H.H.P., An empirical test of the impact of management self-interest on corporate capital structure. Journal of Finance 43, Ginarte, J.C., Park, W.G., Determinants of patent rights: a cross-national study. Research Policy 26, Hall, B.H., Research and development at the firm level: does the source of financing matter. NBER Working Paper No Hall, B.H., The financing of research and development. Oxford Review of Economic Policy 18, Harhoff, D., Are there financing constraints for R&D and investments in German manufacturing firms? Anneles d Economie et de Statistique 49/50, Himmelberg, C.B., Petersen, B.C., R&D and internal finance: A panel study of small firms in high-tech industries. Review of Economics and Statistics 76, Jensen, R., Showalter, D., Strategic debt and patent races. International Journal of Industrial Organization 22, Kaplan, S., Zingales, L., Do investment-cash flow sensitivities provide useful measures of financing constraints? Quarterly Journal of Economics 112, Kanwar, S., Evenson, R., On the strength of intellectual property rights that nations provide. Journal of Development Economics 90, La Porta, R., Lopez-de-Silanes, F., Shleifer, A., Vishny, R., Law and finance. Journal of Political Economy 106, La Porta, R., Lopez-de-Silanes, F., Shleifer, A., Vishny, R., The quality of government. Journal of Law, Economics, and Organization 15, La Porta, R., Lopez-de-Silanes, F., Shleifer, A., Vishny, R., Agency problems and dividend policies around the world. Journal of Finance 55, Lin, C., Lin, P., Song, F., Property rights protection and corporate R&D: evidence from China. Working Paper. 24

25 Love, I., Financial development and financing constraints: international evidence from the structural investment model. Review of Financial Studies 16, Marron, D.B., Steel, D.G., Which countries protect intellectual property? The case of software piracy. Economic Inquiry 38, Mulkay, B., Hall, B.H., Mairesse, J., Investment and R&D in France and in the United States, in Deutsche Bundesbank (ed.), Investing Today for the World of Tomorrow. Myers, S., Determinants of corporate borrowing. Journal of Financial Economics 5, Nini, G., Smith, D., Sufi, A., Creditor control rights and firm investment policy. Journal of Financial Economics 92, Ostergard, R. L., The measurement of intellectual property rights protection. Journal of International Business Studies 31, Park, W.G., International patent protection: Research Policy 37, Rajan, R., Zingales, L., What do we know about capital structure? Some evidence from international data. Journal of Finance 50, Roberts, M., Sufi, A., Control rights and capital structure: an empirical investigation. Journal of Finance 64, Smith, C., Warner, J., On financing contracting: an analysis of bond covenants. Journal of Financial Economics 7, Wooldridge, J., Introductory Econometrics: A Modern Approach. South-Western College Publishing, Thomson Learning. Wu, H., Entry barriers, property rights, and R&D activities: evidence from OECD countries. Working Paper, University of Alberta. 25

26 Table 1: Descriptive statistics The data is collected from Worldscope for the period Sample period varies by countries depending on data availability. R&D is Research & Development expenditures, which are scaled by assets, Eq.R is Equity Ratio, which is the ratio of total shareholders equity to total assets, CF is Cash Flow calculated as Net Income plus Depreciation plus R&D expenditures and scaled by total assets, MB is Market to Book measured as the ratio of the sum of the market value of equity and book value of debt to book value of assets, Sz is Size as the natural logarithm of total assets measured in US Dollar, and AS is the proxy for the adverse selection cost measured by the idiosyncratic volatility, which is computed as the standard deviation of the firm s monthly stock price returns minus local market returns. All these variables are calculated as the mean of available data in the sample period. M (Market) is 1 if the country is a market-based and 0 if it is a bank-based country as defined in Demirguc-Kunt and Levine (2001) and Demirguc-Kunt and Maksimovic (2002). IPR is Intellectual Property Rights measured by the patent rights index. CR is creditor rights from Djankov et al., (2007). Significance of differences between means and medians are based on t-test for the mean differences and Wilcoxon Rank test for median differences. The symbol a denotes statistical significance at 1% level. # of Period R&D Eq.R. CF MB Sz AS M IPR CR Firms Start-End Mean Median Mean Median Mean Median Mean Median Mean Median Mean Median Argentina Australia Austria Belgium Brazil Canada Chile China Czech Rep NA 3 Denmark Finland France Germany Greece Hong Kong Hungary India Indonesia NA 2 Ireland Israel Italy Japan Jordan NA NA Luxemburg Malaysia Mexico Netherlands New Zealand Norway Pakistan

27 # of Period R&D Eq.R. CF MB Sz AS M IPR CR Firms Start-End Mean Median Mean Median Mean Median Mean Median Mean Median Peru Philippines Poland Russian F NA 2 Saudi Arabia NA NA 0 NA. Singapore Slovakia NA 2 South Africa South Korea Spain Sri Lanka Sweden Switzerland Taiwan Turkey Un. Kingdom United States All Sample Developed Developing Difference Test Statistics (29) a [43] a (4.6) a [5.0] a (-14) a [-8.8] a (18) a [23] a (-3.9) a [-4.8] a (8.2) a [-1.0] (7.5) a (0.4) Market Based Bank Based Difference Test Statistics (34) a [22] a (18) a [17] a (-25) a [-9.1] a (29) a [26] a (-44) a [-39] a (28) a [32] a (-0.5) (0.4) All without US Developed Developing Difference Test Statistics (20) a [29] a (-4.1) a [-4.4] a (-5.9) a [-3.0] a (7.4) a [9.5] a (9.3) a [10] a (-8.8) a [-21] a (7.5) a (0.5) Market Based Bank Based Difference Test Statistics (8.8) a [-4.2] a (8.8) a [8.0] a (-9.9) a [-2.2] a (11) a [8.6] a (-31) a [30] a (13) a [18] a (-0.8) (0.5) 27