Working Paper Series in Economics and Institutions of Innovation,
Royal Institute of Technology, CESIS - Centre of Excellence for Science and Innovation Studies

Abstract: Information problems and lack of collateral value should make R&D more susceptible to financing frictions than other investments, yet existing evidence on whether financing constraints limit R&D is decidedly mixed, particularly in studies of non-U.S. firms. We study a large sample of European firms and also find little evidence of binding finance constraints when we estimate standard investment-cash flow regressions. However, we find strong evidence that the availability of finance matters for R&D once we directly control for: i) firm efforts to smooth R&D with cash reserves, and ii) firm use of external equity finance. Our study provides a framework for evaluating financing constraints when firms rely extensively on external finance and endogenously manage buffer stocks of liquidity to keep investment smooth, and our findings show that controlling for this smoothing behavior is critical for uncovering the full effect of financing constraints. Our findings also indicate a major role for external equity in financing R&D, highlighting a causal channel through which stock market development and liberalization can promote economic growth by increasing firm-level innovative activity.

Keywords: Financing innovation; R&D financing constraints; Finance and growth; Stock market development; Value of liquidity

JEL-codes: G31; G32

41 pages, January 21, 2015

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