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Review of Quantitative Finance and Accounting

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27.03.2019 | Original Research

R&D Investment timing, default and capital structure

verfasst von: Daniela Bragoli, Flavia Cortelezzi, Pierpaolo Giannoccolo, Giovanni Marseguerra

Erschienen in: Review of Quantitative Finance and Accounting | Ausgabe 3/2020

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Abstract

This paper investigates the interaction between R&D investment timing, probability of default, and capital structure. In particular we are interested in studying the investment behaviour of three different types of firms according to their capital structure: firms that only use internal funds as a source of funding (unlevered), firms that use debt and that are able to attract unlimited amount of funds (levered unconstrained) and finally firms that use debt, but are not able to attract all the amount needed (levered constrained). We consider irreversible investments in R&D with uncertain returns, financed through debt. We show that debt financing (with or without constraints) significantly alters the standard results in the real option literature. First, we show that leverage distorts the investment threshold and shareholders of a levered firm tend to accelerate investment with respect to an all equity financed firm. This finding is explained by the fact that the increase in the probability of default, which is positively correlated with leverage, might induce a potential loss of the investment option and thus reduce the value of the option to wait providing equity holders with an incentive to speed up the investment. Second, if we introduce the financial constraint, the investment threshold is characterized by a U-shaped relation. The latter implies that the investment threshold diminishes as the financial constraint becomes less stringent, but up to a certain minimum value. After a certain amount of leverage the firm attitude towards R&D investment changes. The firm becomes more risk adverse, given the much higher probability of default (linked to a much higher leverage in its balance sheet).

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On the Italian evidence, see Bragoli et al. (2016).

According to the ECB (2009) latest Survey on the Access to Finance of SMEs in the Euro Area (SAFE), access to finance remained the second most pressing problem for Euro Area SMEs leading to the possible under provision of R&D investment in the economy.

Under investment is in this literature related to the fact that most firms do not invest in R&D, because they postpone their choice of carrying out an innovative project. We are not referring to the amount spent in R&D.

This result is in line with the ‘less money, less innovation’ story.

See Hu et al. 2013, on the impact of managerial flexibility.

Examples of real options applications include patent valuations (Schwartz 2004), oil field valuations, software platform selections, pharmaceutical R&D opportunities, multiphase projects within the telecommunications industry, and investments in renewable energy. For a complete review on Real Option Approach to investment decisions see, e.g., Trigeorgis and Tsekrekos (2017). More recently, see Jones (2018) to explain pattern of R&D using Real Option.

We do not have the presumption of modelling all the features of R&D investment (for this purpose see Schwartz 2004). We simplify R&D investment characteristics in order to be able to study the complex interaction between R&D investment timing, capital structure and company foreclosure.

The firm chooses the date on which to undertake an instant R&D investment (I) that offers it a chance of developing an innovation, once the innovation comes to place it is immediately patented and commercialized. We do not deal with the cumulative effects of innovation efforts.

A constant hazard rate is independent of the duration of research since the earlier entry by a firm into the research phase may not guarantee the firm to be the eventual winner of the R&D race as in the literature on R&D races, see Loury 1979; Dasgupta and Stiglitz 1980. For robustness, we also model the probability of success to increase with the instant R&D investment rate, though this does not change the constant hazard rate assumption and does not change the main results of the paper. We thank a referee for this suggestion, results are available upon request.

The uncertainty in the model is described by a complete filtered probability space \(\left( \Omega ,{{\mathcal {F}}},\left\{ {{\mathcal {F}}}\right\} _{t\in \left( 0,\infty \right) },P\right) ,\) where \(\Omega\) is the state space, \({\mathcal { F}}\) is the \(\sigma\)-algebra representing measurable events, and P is the (actual) probability measure. The filtration is the augmented filtration generated by the Brownian motion and satisfies the usual conditions. A filtration \(\left\{ {{\mathcal {F}}}_{t}\right\}\) satisfies the usual conditions if it is right continuous and \({{\mathcal {F}}}_{0}\) is continuous at all the P-null sets in \({{{\mathcal {F}}}}\).

The restriction \(\mu <r\), commonly found in real option literature, is necessary to ensure that there is a strictly positive opportunity cost to holding the option so that it will not be held indefinitely. Moreover, \(\mu\) is non negative.

For example, the moral hazard and agency problems discussed by Jensen and Meckling (1976) make it difficult for firms to issue claims (either debt or equity) against the full project value. Alternatively, the friction might arise because of the contractual problems analysed by Hart and Moore (1994): the inability to commit vital human capital to the project restricts the supply of new funding.

See, for example, Loury (1979), Dasgupta and Stiglitz (1980), Lee and Wilde (1980) and Dixit (1988).

In alternative, the firm can issues risky debt.

We follow Leland 1994, 1998.

The value of the option to invest in a strategic R&D project follows directly from Proposition 1.

See Leland (1994) for similar results.

In other words, when \(q\rightarrow 0\), our problem tends to the investment decision problem under all-equity financing, which is the standard real options model developed by McDonald and Siegel (1986). When q is sufficiently large, our problem tends to be the investment and financing decisions problem for the non-constrained debt-equity financed firm, which is the simple version of Sundaresan and Wang (2007).

However, as noted by in order to gauge the overall effect of uncertainty on investments, we should look at the probability that the investment will take place (i.e. whether the critical trigger value will be reached within a specified time period). In this sense it turns out that, in certain scenarios, increased uncertainty could actually make investment more likely.

See Dixit & Pindyck (1994), pp. 142–143.

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Titel: R&D Investment timing, default and capital structure
verfasst von: Daniela Bragoli
Flavia Cortelezzi
Pierpaolo Giannoccolo
Giovanni Marseguerra
Publikationsdatum: 27.03.2019
Verlag: Springer US
Erschienen in: Review of Quantitative Finance and Accounting / Ausgabe 3/2020
Print ISSN: 0924-865X
Elektronische ISSN: 1573-7179
DOI: https://doi.org/10.1007/s11156-019-00807-6

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