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A Reexamination of the Tradeoff Between the Future Benefit and Riskiness of R&D Increases

32 Pages Posted: 10 Aug 2007  

Allan Eberhart

Georgetown University

William F. Maxwell

SMU - Cox School

Akhtar R. Siddique

Government of the United States of America - Risk Analysis Division

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Abstract

Many previous studies document a positive relation between research and development (R&D) and equity value. Though R&D can increase equity value by increasing firm value, it can also increase equity value at the expense of bondholder wealth through an increase in firm risk because equity is analogous to a call option on the underlying firm value. Shi (2003) tests this hypothesis by examining the relation between a firm's R&D intensity and its bond ratings and risk premiums at issuance. His results show that the net effect of R&D is negative for bondholders. We reexamine Shi's findings and in so doing make three contributions to the literature. First, we find that Shi's results are sensitive to the method of measuring R&D intensity. When we use what we argue is a better measure of R&D intensity, we find that the net effect of R&D is positive for bondholders. Second, when we use tests that Shi recognizes are even better than the ones that he uses, we find even stronger evidence of the positive effect of R&D on bondholders. Third, we examine cross-sectional differences in the effect of R&D on debtholders. Consistent with our main finding, we document a negative relation between R&D increases and default risk. The default risk reduction is also more pronounced for firms with higher initial default scores (where the debtholders have more to gain from an R&D increase) and for firms with more bank debt (where the debtholders have greater covenant protection from the possible detriments associated with R&D increases).

Keywords: R&D Benefits and Detriments, Bonds, Agency Conflicts, Option Pricing

JEL Classification: M41, G10, G31, G32

Suggested Citation

Eberhart, Allan and Maxwell, William F. and Siddique, Akhtar R., A Reexamination of the Tradeoff Between the Future Benefit and Riskiness of R&D Increases. Journal of Accounting Research, Forthcoming. Available at SSRN: https://ssrn.com/abstract=1005473

Allan C. Eberhart (Contact Author)

Georgetown University ( email )

McDonough School of Business
Washington, DC 20057
United States
202-687-4584 (Phone)

William F. Maxwell

SMU - Cox School ( email )

Maguire Bldg, RM 440C
Dallas, TX, TX 75214
United States

Akhtar R. Siddique

Government of the United States of America - Risk Analysis Division ( email )

400 7th Ave
Washington, DC 20219
United States
202-649-5526 (Phone)

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