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

Many previous studies document a positive relation between research and development (Ramp;D) and equity value. Though Ramp;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 Ramp;D intensity and its bond ratings and risk premiums at issuance. His results show that the net effect of Ramp;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 Ramp;D intensity. When we use what we argue is a better measure of Ramp;D intensity, we find that the net effect of Ramp;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 Ramp;D on bondholders. Third, we examine cross-sectional differences in the effect of Ramp;D on debtholders. Consistent with our main finding, we document a negative relation between Ramp;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 Ramp;D increase) and for firms with more bank debt (where the debtholders have greater covenant protection from the possible detriments associated with Ramp;D increases)