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The Handbook of Technology and Innovation Management by Scott Shane

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15.4. Testing for Financial Constraints

The usual way to examine the empirical relevance of the arguments that R&D investment in established firms can be disadvantaged when internal funds are not available, and recourse to external capital markets required, is to estimate R&D investment equations and test for the presence of 'liquidity' constraints, or excess sensitivity to cash flow shocks. This approach builds on the extensive literature developed for testing ordinary investment equations for liquidity constraints (Fazzari, Hubbard, and Petersen, 1988; Arellano and Bond, 1991). It suffers from many of the same difficulties as the estimates in the investment literature, plus one additional problem that arises from the tendency of firms to smooth R&D spending over time.

The ideal experiment for identifying the effects of liquidity constraints on investment is to give firms additional cash exogenously, and observe whether they pass it on to shareholders or use it for investment and/or R&D. If they choose the first alternative, either the cost of capital to the firm has not fallen, or it has fallen but they still have no good investment opportunities. If they choose the second, the firm must have had some unexploited investment opportunities that were not profitable using more costly external finance. A finding that investment is sensitive to cash flow shocks that are not signals of future demand increases would reject the hypothesis that the cost of external funds is the same as ...

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