The valuation of corporate R&D expenditures: Evidence from investment opportunities and free cash flow

Corporate research and development (R&D) investments are carefully scrutinized as indicators of competitiveness and corporate strength. The availability or lack of growth opportunities can be an important consideration in assessing the value-enhancing features of R&D investments. The investment opportunities hypothesis holds that R&D investments by fins with promising growth opportunities are generally worthwhile, whereas other R&D investments may be wasteful. Similarly, the availability or lack of free cash flow may also be an important consideration in determining the value-enhancing potential of R&D investments. The free cash flow hypothesis predicts a differential market response, depending on the firm's level of free cash flow. This study provides additional evidence that supports the investment opportunities hypothesis and shows that the market response to announced increases in R&D expenditures depends on a firm's investment opportunities. Firms with greater investment opportunities have a significantly positive stock price reaction to announcements of R&D expenditures. In contrast, firms with relatively fewer investment opportunities have a negative stock price reaction to announcements of R&D expenditures. These relationships hold even after controlling for the effect of other potentially influential variables. The evidence does not fully support the free cash flow hypothesis. No cross-sectional differences in abnormal announcement-period returns are found. However, we find tentative evidence of an interaction between free cash flow and a firm's investment opportunities. This difference between firms with high and low investment opportunities is most pronounced for firms with a low cash flow ratio. Also, the evidence shows positive effects for a firm's debt ratio and its proportion of institutional ownership. A high debt ratio implies precommitted future cash flows and greater institutional oversight, both of which can lower the expected agency costs of free cash flow. We conclude that the evidence may support a broad interpretation of the free cash flow hypothesis. We measure a firm's investment opportunities using Tobin's q, the ratio of the market value of the firm's assets to their replacement cost. Our sample of R&D increase announcements by 121 NYSE- and AMEX-listed firms between 1979 and 1992 is partitioned into high- and low-q firms (above vs. below one). A firm's free cash flow is measured by its cash flow ratio, which is operating income before depreciation minus interest expense, taxes, preferred dividends, and common dividends, divided by the book value of total assets. We also partition the sample into firms with high and low cash flow (above vs. below the sample median). Stock price reaction is measured by the two-day abnormal announcement period return using standard event-study methodology.