We thank Abbie Smith and an anonymous referee for their helpful comments. We also thank Ashiq Ali, Ken Cavalluzzo, Dan Dhaliwal, Thomas Lys, Lillian Mills, Annette Poulsen, Mark Trombley, and seminar participants at the University of Arizona for their helpful comments. Eberhart received support from a Georgetown University Summer Research Grant and a Steers Faculty Fellowship. Maxwell and Eberhart received support from the Georgetown University Capital Markets Research Center. The views expressed are those of the authors and do not necessarily represent those of the Comptroller of the Currency.
A Reexamination of the Tradeoff between the Future Benefit and Riskiness of R&D Increases
Version of Record online: 17 DEC 2007
Journal of Accounting Research
Volume 46, Issue 1, pages 27–52, March 2008
How to Cite
EBERHART, A., MAXWELL, W. and SIDDIQUE, A. (2008), A Reexamination of the Tradeoff between the Future Benefit and Riskiness of R&D Increases. Journal of Accounting Research, 46: 27–52. doi: 10.1111/j.1475-679X.2007.00264.x
- Issue online: 17 DEC 2007
- Version of Record online: 17 DEC 2007
- Received 1 February 2005; accepted 22 June 2007
Many previous studies document a positive relation between research and development (R&D) and equity value. Though R&D can increase equity value by increasing firm value, it can also increase equity value at the expense of bondholder wealth through an increase in firm risk because equity is analogous to a call option on the underlying firm value. Shi  tests this hypothesis by examining the relation between a firm's R&D intensity and its bond ratings and risk premiums at issuance. His results show that the net effect of R&D is negative for bondholders. We reexamine Shi's  findings and in so doing make three contributions to the literature. First, we find that Shi's  results are sensitive to the method of measuring R&D intensity. When we use what we argue is a better measure of R&D intensity, we find that the net effect of R&D is positive for bondholders. Second, when we use tests that Shi  recognizes are even better than the ones that he uses, we find even stronger evidence of the positive effect of R&D on bondholders. Third, we examine cross-sectional differences in the effect of R&D on debtholders. Consistent with our main finding, we document a negative relation between R&D increases and default risk. The default risk reduction is also more pronounced for firms with higher initial default scores (where the debtholders have more to gain from an R&D increase) and for firms with more bank debt (where the debtholders have greater covenant protection from the possible detriments associated with R&D increases).