What Finances R&D? R&D, Cash Flow Sensitivities, and Financing Constraints

Treating the potential endogeneity problems of the empirical specifications in prior studies, I employ a dynamic multi-equation model in which firms make interdependent decisions in financing, investment, and distribution, under the constraint that sources and uses of cash must be equal. I argue that the large R&D-cash flow sensitivities found in prior studies are mostly due to the lack of controlling for the interdependence and intertemporal nature of firm policies. My results show little support for prior arguments that high-tech firms are financially constrained based solely on large cash flow effects on R&D. I argue that, instead of focusing on R&D-cash flow sensitivities alone, it is more appropriate to study financing constraints by investigating the asymmetry in firm responses to positive and negative cash flow shocks. Using this approach, my findings indicate that young high-tech firms are constrained, based on their significantly lower capability to absorb negative cash flow shocks than to accommodate positive ones. In addition, I find young and mature firms rely on different financing sources for innovation: young firms finance innovation through internal and external equity, while mature firms use cash flow and debt for R&D financing. R&D and physical capital investment are likely to be complementary for mature, but not for young, firms