Finance

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As it was mentioned, since debt increases the risk of bankruptcy managers are forced to manage the business effectively, as in the case of bankruptcy they will lose their jobs. The creditors possess legal right to sue the firm, if it fails to meet its obligations. In order to avoid the risk of liquidation managers utilize resources efficiently and follow a value maximizing business policy. Debt serves as a disciplining mechanism to prevent managers to divert from their primary goal.

Agency problem and R&D

In the recent decades, the impact of research and development expenditures on firm value has been analyzed. The analyses (Chan, Martin and Kessinger 1990, (Chauvin& Hirschey 1993) has shown the reaction of the stock market has been positive towards research and development investment announcements. As in was mentioned, since research and development contributes to the competitive advantage of firms by creating innovation and bringing higher productivity, the markets expectation about the firm go up after the research and development investment increase announcements. Research and development expenditures create intangible capital for the company. Present value of expected return from research and development should be reflected in the valuation of the company by the market. Research and development is a risky activity. However if the initiative is successful the company is awarded with monopoly power. The market understands both aspects, the risk and the future return, and captures them in the market value of the company or one of its derivative measures, such as Tobin’s Q (Johnson&Pazderka 1993). In regards to research and development, it can be said that value of the company also includes present value of its expected profits from R&D adjusted for risk.

Divergence in the objectives of managers and shareholders can lead to disagreement over the determination of strategic direction of the firm. One of the issues that trigger conflict between managers and stockholder is a firm’s corporate R&D strategy. “High investment in R&D is generally a high risk-high return strategy” which can be in the interest of shareholders. Shareholders can mitigate the inherent risk by creating a diversified investment portfolio. However, managers who perceive high failure risk in R&D projects tend to stay away from those projects. In addition, innovative projects usually have long-term return. Since managers’ salaries depend on the performance of a firm and R&D projects are risky and yields are not immediately apparent in the performance reports, manager will opt for lower risk projects which yield mediocre short-term returns (Baysinger et. al. 1991).

Hypothesis

Based on the previous discussion I make two hypotheses:

- There is a significant negative relationship between level of corporate R&D spending and agency problem.

Based on the previous discussion, agency problem will be lower in the presence of higher debt ratio in the capital structure of a firm, higher concentration of equity ownership among stockholders and higher number of analysts covering the firm. The rationale is that when agency problem is low, the intentions of managers and shareholders converge, because it is in the interests of shareholder to invest in R&D projects, so it is expected that in firms with lower agency problem, managers will allocate more on R&D expenditure.

- Firms with lower agency problem will benefit more from R&D than firm with higher agency problem.

In those firms where cash flow is low (due to the interest (because of higher debt ratio) and dividend payments), creditor monitoring and the number of analysts are high; managers will take a responsible stance on research and development expenditure. They will evaluate R&D projects very carefully before they invest, because first they know that they closely watched and second they are well aware that in the case of failure their probability of bankruptcy (unemployment) is higher (than unlevered firm).

METHODS

Data

In order to test the hypothesis, the data of 556 companies have been collected. Only European companies have been selected, because European countries are among the developed countries where firms considerably invest in R&D projects. Second, European countries have strong rule of law and legal institutions as well as well-developed financial markets which to certain extent reduce agency problem.

Dependent and independent variables