Innovation, leverage and internal controls

John Francis Burr, Purdue University

Abstract

This research proposal is motivated by literature that suggests firms wishing to be innovators need lower leverage. In this work, we seek to address the question, "when can innovation and debt co-exist?" Empirical evidence shows a reduction of R&D intensity as leverage increases, implying that firms wishing to make investments in research and development will do so at the expense of the benefits of debt. Unfortunately, nearly all previous work has failed to articulate a mechanism by which innovation proceeds in the presence of debt. It is also assumed in the agency literature that reduction of free cash flow will increase the average quality of investment as lower value adding projects are culled out of the mix. Nearly all previous work has failed to investigate a key assumption in the agency literature—whether the reduction in slack, through the manipulation of debt, is an appropriate governance mechanism for the outcomes associated with investments in R&D. This work suggests that innovation in the form of technical exploration may provide better collateral potential than exploitation and may allow debt to co-exist with exploration. This work also suggests that the internal controls on project selection change depending on the levels of debt and slack. Ultimately, the restriction of experimentation through reduction of slack has a negative effect on the technological impact of a firm. Contrary to the agency perspective, this work finds that R&D investment in the presence of free cash flow may not suffer from agency problems or decreasing marginalization to which financial control is the solution.

Degree

Ph.D.

Advisors

Brush, Purdue University.

Subject Area

Management|Finance

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