Research and development, profits, and firm value: A structural estimation

Missaka Warusawitharana
2015 Quantitative Economics  
This study presents a model in which firms invest in R&D to generate innovations that increase their underlying profitability and invest in physical capital to produce output. Estimating the model using a method of moments approach reveals that R&D expenditures contribute significantly to profits and firm value. The model also captures variation in R&D intensity, profits and firm value across R&D-intensive industries. Counterfactual experiments suggest that changes in distribution of firms in
more » ... e economy may, over the long-run, mitigate tax policy changes designed to encourage R&D expenditures. Tobin's q, measured as the market value of the firm divided by the replacement cost of capital, and profitability, measured as operating income divided by capital. An examination of the data indicates that firms in the sample have, on average, high R&D intensities. These firms also have high Tobin's q values that cannot be justified solely based on investment frictions, suggesting that R&D investment plays in important role in understanding their profits and firm values. The estimates reveal that R&D expenditures have an economically and statistically significant impact on profits and firm value. The findings imply that firms obtain jumps in profitability from successful innovations in most periods. On average, firms expect their R&D expenditures to generate about an 18.5% increase in the underlying profitability process. These profitability increases are also quite persistent. The large persistent expected profitability increases arising from R&D expenditures enable the model to match the high levels of R&D expenditures observed in the data as well as the high Tobin's q levels. In addition, the model captures the low correlation between Tobin's q and investment observed in the data. Also, the estimation yields an obsolescence rate for R&D stocks of about 32%, somewhat higher than the value of 15% typically used in the literature (see Griliches and Mairesse (1984) ). An extension of the model that allows for R&D expenditures to influence both the success rate of innovations and the increase in profitability arising from an innovation generates broadly similar findings. Firms expect innovations to lead to about a 20% increase in profitability, and the estimated obsolescence rate of R&D equals 23%. Estimating the model on selected R&D-intensive industries-chosen based on four-digit SIC codes-demonstrates that the model successfully captures variations in R&D intensity, profitability and firm value across these industries. The results from each of these industries reveal that while firms face uncertainty in the outcomes from their R&D expenditures, they can realize economically meaningful increases in profits from innovations. This estimation also highlights the importance of the non-R&D-related parameters, with both the curvature of the profit function and the persistence of shocks to the profitability process influencing firms' R&D expenditures. The study carries out a number of related analysis to address identification concerns regarding the R&D-related parameters. An examination of the GMM-objective function minimized in the estimation reveals that the function is steeply sloped at the estimated parameter values, enabling identification. This steep slope arises from the fact that the moments chosen in the study are sensitive to changes in the underlying parameters. Finally, the estimation method is able to recover the underlying parameter values when applied to data obtained from simulating the model. The structural estimation approach enables a counterfactual experiment on an increase in the
doi:10.3982/qe282 fatcat:bi3bdsthubgg5fgovvyzvzzuce