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The Handbook of Technology and Innovation Management by Scott Shane

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15.3. Theoretical Background

This section reviews the reasons why the impact of financial considerations on the investment decision may vary with the type of investment and with the source of funds in more detail. To do this, I distinguish between those factors that arise from various kinds of market failures in this setting and the purely financial (or tax-oriented) considerations that affect the cost of different sources of funds.

One of the implications of the well-known Modigliani-Miller theorem (Modigliani and Miller, 1958; Miller and Modigliani, 1961) is that a firm choosing the optimal levels of investment should be indifferent to its capital structure, and should face the same price for all types of investment (including investments in creating new products and processes) on the margin. The last dollar spent on each type of investment should yield the same expected rate of return (after adjustment for nondiversifiable risk). A large literature, both theoretical and empirical, has questioned the bases for this theorem, but it remains a useful starting point.

There are several reasons why the theorem might fail to hold in practice:

  • uncertainty coupled with incomplete markets may make a real options approach to the R&D investment decision more appropriate;

  • the cost of capital may differ by source of funds for non-tax reasons;

  • the cost of capital may differ by source of funds for tax reasons;

  • the cost of capital may also differ across types of investments (tangible and intangible) ...

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