North American Journal of Economics and Finance 50 (2019) 100991

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North American Journal of Economics

and Finance
journal homepage: www.elsevier.com/locate/najef

Tangible and intangible investment in corporate finance

T
Zhao Shuanglinga,
⁎,1
, Cao Guohuaa, Wu Lijuanb,c,
⁎,1

a
School of Economics and Business Administration, Chongqing University, Chongqing 400030, China
b
Big Data Decision Institute (BDDI), Jinan University, Guangzhou 510632, China
c
Guangdong Engineering Technology Research Center for Big Data Precision Healthcare, Guangzhou 510632, China

ARTICLE INFO ABSTRACT

Keywords: Research and development (R&D) investment has increased dramatically in recent decades but
R&D investment not been explored extensively implications for the firms’ liquidity management. In this paper, we
Physical investment propose a dynamic model of a financially constrained firm about R&D and physical investment,
q theory financing and risk management, and then analyze the market-timing decisions about the cor-
Market timing
porate liquidation, external equity, credit debt and payout. And the comparative static analysis
Risk management
about R&D is also given. We find that the firm value changes sharply with the obsolescence rate
of R&D, the volatility of R&D stocks will decrease the firm value-capital ratio, and R&D invest-
ment is more impressionable to financing frictions than physical investment. Our model and
analysis provide the new insight into the investment and financing of intangible capital.

1. Introduction

As we all know, it has long been viewed that research and development (R&D) investment is an important and necessary de-
terminant for innovation and productivity growth. Especially, in recently, the European Union set an objective to continue to spend
more on R&D investment as an important stimulus for fostering Europe’s competitiveness. South Korea, which is famours for the
imported fossil energy, has made a plan to continually increase the R&D investment to develop and commercialize renewable energy
technologies for future growth. Overall, investment on R&D has been growing faster than tangible investment over the last 20 years.
However, investments in intangible assets tend to be underestimated. The system of national accounts captures only about half of all
spending on intangible assets and corporate financial reports commonly provide only limited information on companies’ investments
in intangibles. To address this problem, our paper aim to analyse the relation between R&D investment and firm value.
At present, the researches on R&D investment are mainly the empirical regression model and the dynamic discrete model based on
the production function, they argue that from many aspects, including growth, productivity and firm value. Some studies such as
(Andrews & De Serres, 2012; Corrado, Hulten, & Sichel, 2009; Doraszelski & Jaumandreu, 2013; Jorgenson & Stiroh, 2000; Oliner &
Sichel, 2000; Roth & Thum, 2013) have examined the impact of R&D investment on economic growth or productivity. Empirical
findings represent that, in most of the countries observed, the contribution of total intangible assets to output growth is between one
and three times that of tangible assets.
Some studies such as Eberhart, William, and Akhtar (2004), Hall, Adam, and Manuel (2005), Rubera and Kirca (2012), Yu, Liu,
Fung, and Leung (2018) have examined the value effects of R&D investment, Other studies find that output measures of R&D
investments, such as patents or Food and Drug Administration drug approvals, are positively related to firm value. Hall et al. (2005)

⁎
Corresponding authors at: Big Data Decision Institute (BDDI), Jinan University, Tianhe, Guangzhou 510632, China (W. Lijuan).
E-mail addresses: zsl_n1987@126.com (Z. Shuangling), caoguohua@cqu.edu.cn (C. Guohua), wulj1989@163.com (W. Lijuan).
1
These authors contributed equally to this work.

https://doi.org/10.1016/j.najef.2019.100991
Received 8 January 2018; Received in revised form 11 March 2019; Accepted 13 May 2019
Available online 15 May 2019
1062-9408/ © 2019 Elsevier Inc. All rights reserved.
Z. Shuangling, et al. North American Journal of Economics and Finance 50 (2019) 100991

show that “knowledge stock” or innovation output, measured by patent counts or patent citations, are significantly related to firms’
market values. Rubera and Kirca (2012) find that smaller firm with strong R&D investment is a positive signal for firm valuation.
Warusawitharana (2015) estimates that the R&D expenditures contribute significantly to profits and firm value. Yu et al. (2018) using
monthly US stock data from 1962 to 2017 have showed that R&D intensity at firms adds another important dimension to the size and
value effects in describing stock returns, especially for small high-tech firms.
Overall, the rise in the importance of R&D investment to firm value also means that it is important to make investment strategy.
However, they do not consider the interaction between investment and financing decisions, and extremely limited theoretical re-
search can explain the following problem:when the firm faces the problem of financing constraint, how to make the optimal R&D
investment, entity investment, financing and risk management strategy to maximize the firm value?
We address these questions in a model of dynamic investment, financing, and risk management for financially constrained firms.
Our paper is most closely related to a number of dynamic models of investment with financial constraints including Bolton, Chen, and
Wang (2011), Gomes (2001), Hennessy and Whited, 2005, 2007, Jiang, Xia, and Yang, 2018, Riddick and Whited, 2009. However, all
these models does not distinguish tangible and intangible investments. According to Hall (2001), if intangible capital is an important
factor of production, the marginal product of physical capital will depend on the quantity of intangible capital. Therefore, a firm
ignoring R&D investment and dynamics significantly distorts its investment and reduces its value. Our model builds on the recent
dynamic frameworks by Bolton, Chen and Wang (BCW), mainly by adding the R&D investment. The definition of K is the level of
physical capital for production in BCW, while in our paper it is the total capital including both the tangible capital and intangible
capital, which is the same to the definition in Jiang et al. (2018).
The closest in spirit to our model is that of Klette and Kortum (2004). In that model the investment on R&D could yield an
innovation to add a new product or process innovation for a particular good, both of the firm and the economic grows by innovating
in new products and in raising the quality of a given set of products separately. The most important property of the model is that a
firm of any size can be analyzed in terms of its marketing divisions or production division and research divisions. Within the
framework of this paper, the firm produces output using physical capital and exploiting the associated R&D capital to engage in new
research. It is therefore possible to think of a firm as consisting of a production division whose operating revenue is based on the
production function and research division whose potential revenue is related to the degree of the R&D capital accumulation and
whether the innovation is successful.
Our paper is also relate to another paper of Warusawitharana (2015), who studys the R&D investment in the setting of a dynamic
discrete model. Both of us allow for R&D stocks to influence the probability of innovation, hence, the R&D stock stochastically affects
the transition of profitability across periods. One feature of our model is that we work in continuous time and R&D investment model
is made by using stochastic differential equation. Another feature of our model is that, based on the study of Aghion and Howitt
(1990), the probability of success not only depend on the R&D spending and R&D capital stock, but also rely on the flow of R&D and
the current technical levels of both the firm and whole society.
This study contributes to the extant literature by employing the recent dynamic frameworks of BCW, mainly by adding the R&D
investment and the stochastic R&D capital accumulation process. The main results of our analysis are as follows. Firstly, we find that
R&D investment is more impressionable to financing frictions than physical investment. Secondly, we find that the firm value changes
sharply with the obsolescence rate of R&D investment. Thirdly, we find the volatility of R&D stocks will decrease the firm value-
capital ratio. Overall we contribute to the literature by highlighting the role of R&D investment in firm valuation and portfolio
construction.
The remainder of the article proceeds as follows: Section 2 establishes the model. Section 3 introduces the model solution; Section
4 presents the quantitative results; Comparative state analysis is presented in Section 5; Section 6 draws the conclusions.

2. Model

This section presents a dynamic structural model of firm’s financing and investment decisions, in the spirit of BCW (2011). The
underlying model used in this paper build on the endogenous growth literature of Klette and Kortum (2004). Firms invest in R&D to
increase the probability of innovations, which lead to increases in the underlying profitability process. The novel feature of our model
is that we incorporate the R&D investment and R&D capital accumulation dynamics. In what follows, we proceed in three steps. First,
we describe the firm’s production and investment technology. Then, we introduce the process of the corporate liquidity accumu-
lation. Finally, we present the firm optimal investment.

2.1. Production and investment technology

The firm’s gross capital in detail can be divided into tangible capital (equipment, property and plant) and firm-specific intangible
R&D capital(brand value, patents and know-how). For simplicity, in our model the firm’s total capital just includes both physical
capital and R&D capital. Let K and I denote the gross level of capital stock and total investment, respectively. As is standard in capital
accumulation models, the change of the gross capital stock K is given by the difference between gross investment and depreciation, in
that:

dKt = (It Kt ) dt + K
K K t dZt , (1)

where 0 is the depreciation rate of total capital, K is the volatility of the gross capital shocks and ZK denotes a standard Brownian

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Z. Shuangling, et al. North American Journal of Economics and Finance 50 (2019) 100991

motion under the risk-neutral probability space( , F , ). We denote by B the firm’s R&D investment, and the accumulation process
of the R&D capital S is assumed as follows:
dSt = (Bt St ) dt + S
S St dZt , (2)
where 0 is the R&D obsolescence rate, s denotes the volatility of the R&D capital shocks, and is another standard Brownian ZS
motion under the same risk-neutral probability space ( , F , ), and the correlation coefficient between the shock to the gross capital
and the shock to the R&D capital is . The absence of a non-negative constraint on R&D investment means that the firm can sell its R&
D if necessary. The assumption of reversibility is also supported by some firms’ anecdotal evidences of selling partially self-devel-
opment products or technologies to other firms (e.g., the pharmaceutical sector).
It is difficult to determine the obsolescence rate of R&D: one of the reasons is that the firmś own behavior and its competitors are
responsible to the obsolescence rate; the other significant reason is that obsolescence rate varies across different industrial sectors,
which have totally diverse levels of competition. According to above two reasons, it is irrational to assume a fixed and constant
obsolescence rate of R&D. The recently paper of Wendy, Li, and Bronwyn (2018) develop a forward looking profit mode to estimate
the depreciation rates of business R&D capital and show that the rates are in general higher than the traditionally assumed 15 percent
and vary across industries. Warusawitharana (2015) demonstrates that the return varies sharply with the assumed value of the
obsolescence rate, and finds it difficult to choose the appropriate obsolescence rate. Considering in the time dimension this rate
usually (but not always) varies slowly, in our model we still assume that rate is constant, and then research the effects of the different
obsolescence rates on the firm value-capital ratio and the marginal value.
We denote the ratio of R&D investment to total investment (i.e., aggregate R&D fraction) at time t by bt = Bt / It , and the ratio of R&
D stocks to total capital stocks at time t by st = St / Kt . Tangible capital equate total capital minus the intangible R&D capital (i.e.,
Kt St ), then the operation revenue of the firm’s physical capital over time increment dt can be given by
(K t St ) dAt (3)
where dAt = µA dt is the firmś productivity shock without R&D over time increment dt. Different from the income of the physical
capital stocks, R&D revenue is mainly connected with the degree of innovation and the profit from a unit of innovation. Meanwhile, R
&D investment have a highly uncertainty and the return of the innovation is both uncertain and lagging. When the firmś R&D activity
successes, the profit will increase, but if the R&D effort fails, the firm will not realize a jump of profitability. We denote the prob-
ability of R&D success by pt , then the expected value of intangible capital revenue over time increment dt is
pt ·Mt · dSt (4)
where we use intangible (R&D) capital accumulation dSt to approximate the size of innovation over time increment dt , Mt denotes the
price of the successful innovation, i.e., the profit from a unit of innovation.
Based on the study of Aghion and Howitt (1990), the probability of a successful R&D activity at time t not only depend on the R&D
capital stock at time t, but also rely on the current technical levels of both the firm and whole society at time t and the flow of R&D
investment at time t. We assume that the probability of R&D success is given by the following relation
pt = 1 (Bt )· 2 (St )· 3 (Gt ) (5)
Firstly, if the firmś current R&D stock St is large, that means that the level of firmsté chnology and human capital development is
very high, which would increase the probability of a successful R&D activity. That is to say, the higher the R&D stocks, St , the bigger
probability of the successful R&D activity. Secondly, the small firm though has a lower R&D stock at time t, he may want to innovate
more as they can sell their firms out to large firms, so they rely on R&D activity for the survival and growth, he may spend more
expenses on R&D project. While, the large firm, though he has a higher R&D stock at time t, he finds it easy to innovate through
acquisition, hence, he spends little expenses on R&D project. According to Rubera and Kirca (2012), smaller firm with strong R&D
investment is a positive signal for firm valuation. Hence, we consider the probability is positively related to the flow of R&D in-
vestment at time t. Finally, we denote the current technology level by Gt . There are two opinions about the relationship between the
probability of a successful R&D activity and the current level of the technology: If innovation becomes more and more difficult, the
probability of R&D success would depend negatively on Gt ; On the contrary, if earlier innovations make the subsequent invention
easier, the probability of R&D success would have a positive correlation with Gt . In our model, we assume that the probability of a
successful R&D activity would be negatively related to Gt , i.e., when the degree of the technology develops to a higher level, the
innovation becomes more difficult. In order to make sure pt (0, 1) , without loss of generality, we assume that

Bt St 1
pt = 1 exp a =1 exp abt st / Gt
It Kt Gt (6)
where a is a parameter that influences the probability of R&D success. This parametrization means that the success probability are
concave in the ratio of R&D investment to total investment, bt = Bt / It , and the ratio of R&D stocks to total capital, st = St / Kt . The
scaling by both total investment and entire capital stock can be regarded as capturing the increase of R&D project with firm size.
Therefore, a larger firm require a higher level of R&D spending to generate the same success probability as a small firm. The role of
scaling guarantees that the large firm would not benefit from the R&D activities disproportionately.
The firm’s increased operating income over time increment dt , dYt , is then given by
dYt = [(Kt St ) dAt (It Bt ) dt 1 (It Bt , Kt St ) dt ] + [Mt pt dSt Bt dt 2 (Bt , St ) dt ], (7)

3
Z. Shuangling, et al. North American Journal of Economics and Finance 50 (2019) 100991

where 1 (It Bt , Kt St ) and 2 (Bt , St ) are the additional adjustment costs of the physical and R&D investment, respectively. The first
term is the firm’s operating revenue from physical capital, and the second term is the firm’s R&D revenue. As Hayashi, 1982 has first
shown, we also assume that both tangible and intangible investment incur a symmetric quadratic adjustment costs.

1
1 I B, K S = (1 b) 2 1 s i2K
2 (8)

2 2 2
2 B, S = b si K
2 (9)
where i = I / K is the firm’s investment capital ratio, 1 and 2 denote the level of quadratic adjustment costs of physical and R&D
investment, respectively. In reality, R&D investment faces a larger adjustment cost than physical investment, because most R&D
spending is wage payments to workers with highly skilled technology.

2.2. Liquidity accumulation

The firm at any time can make the decision of liquidating its assets, then gets a liquidation value Lt , which is proportional to the
firm’s physical capital, since we assume that the obsolescence rate of the R&D capital, , immediately increases to one when the firm
choose liquidation. That is to say, the intangible R&D is totally out of date and eliminated while the firm liquidate its capital.
Specially, Lt = l (K S ), where l > 0 is the liquidation value per unit of physical capital. We denote the time of stochastic liquidation
by .
The company managers could also choose external equity financing. However, in reality, because of managerial incentive issues
and asymmetric information, the firm often incurs the external financing costs. For analytically convenience, we assume that the
external financing costs consist of a fixed cost, = K , and a marginal cost .
Let H denote the cumulative process for the corporate external financing, and dHt denotes the increment of corporate external
financing over time increment dt. Hence we can write the firm’s issuance costs as follows:
dXt = t K t 1{dHt > 0} + t dHt (10)
where 1{dHt > 0} is an indicator function which takes the value of one when dHt > 0 and zero otherwise. Intuitively, when the firm runs
out of cash and want to continue operating, managers may decide to raise external financing incurring the issuance costs. However, if
the costs of external financing is too high or the continuation return is too low, the corporate managers would rather choose to
liquidate the capital rather than raise external funds.
To avoid paying a carry cost > 0 on the corporate retained cash, the firm may choose payout to shareholders, let U denote the
cumulative process of the firm’s payout to shareholders, hence dUt stands for the incremental payout over time dt. The firm’s liquidity
Wt accumulates as follows:
dWt = dYt + (r ) Wt dt + dHt dUt , (11)
where r is the risk-free interest rate. The first term dYt stands for the firm’s operation income; the second term is the net income of
cash holding; the term (dHt dUt ) is the net cash-flow from external financing, which equals the cash flow dHt minuses the cash
outflow to shareholders dUt .

2.3. Firm optimality

The corporation maximizes its shareholder value by choosing the optimal R&D investment B, total investment I, external fi-
nancing H, payout policy U, and liquidation time , as follows

e rt dUt dHt dXt + e r (l (K S ) + W)

(12)
0

Where the expection is taken under the risk-neutral probability. The first term stands for the discounted value of net payout to
corporate shareholders. Since we assume, if the firm choose liquidation, the R&D capital will be completely out of date. Hence, the
second term is the discounted value only from physical capital liquidation. Specially, the case = implies that the firm never
choose to liquidate the capital.

3. Model solution

The corporate value mainly depends on its both cash holdings W and stock of gross capital K. In our model, considering the effect
of aggregate R&D fraction, we denote the firm value by V (s) (W , K ) , where the superscript s denotes the ratio of R&D capital S to total
capital K. Intuitively, when the firm’s cash holdings W are too high, in order to avoid incurring the carry cost, the firm would choose
payout. Let W denote the upper payout barrier. Similarly, if a firm runs out of its cash or cash holdings are low, it always holds the
abandonment option and choose to liquidate at any time. However, if its liquidation value is lower than its going-concern value, the
firm would decide to increase the external funding by the credit or equity financing, and the lower barrier is denoted by W .

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Z. Shuangling, et al. North American Journal of Economics and Finance 50 (2019) 100991

3.1. Liquidation case

In the internal financing region, W < W < W : The firm value V (s) (W , K ) is the solution of the following Hamilton-Jacobi-Bellman
(HJB) equation:
2 2
KK
rV (s) = MaxI , B I K V K(s) + (s )
V KK + r W+ K S µA + B S Mp I 1 2
2
( S SMp)2 (s)
VW(s) + VWW + K S MpSK
(s )
VWK
2 (13)
On the right side of Eq. (13), the first and second term reflect the change of firm value V (s) (W , K ) resulting from the drift and
volatility of the capital stock K, respectively. The third and fourth term represent the effects of the drift and volatility of cash W on the
firm value, respectively. Finally, the last term captures that how the corporate value is affected by the correlation between total
capital K and cash holdings W.
By applying the standard optimality to the HJB Eq. (13) for total investment I and R&D investment B, we get the following first-
order conditions (FOCs):

V K(s)
1+ i= + bMp b, s
VW(s) (14)

Mp (b, s )/i + 1 (1 s )
b=
2 s + 1 (1 s) (15)
where = 1 (1 b)2 (1 s) + 2 b2s . We denote the R&D investment-capital ratio by b as follow

b = b· i (16)
Firstly, notice that both Eqs. (14) and (15) are the implicit equations. Secondly, Eq. (14) characterizes the firm’s optimal total
investment rate, and Eq. (16) gives the optimal R&D investment decision. Finally, the variable b is the ratio of R&D investment to
total investment, thus the value of variable b must be in the region (0, 1), that is to say, the inequality, 0 Mp (b , s ) i 2 s , must be
established.
For simplicity, there are two key simplifications in our model: the ratio of R&D capital S to total capital K , s , is as an exogenous
variable; the second simplified method is the dimension reduction by using the homogeneity as follows:
V (s) (W , K ) = vs (w ) K (17)
where w = W / K is the corporate cash-capital ratio, the dynamics of cash-capital ratio w can be written as

2 1 2 2 2
dw = r+ i + K w+ 1 s µA + bi s Mp i (1 b)2 1 s i2 b si dt + S MpsdZ
S w K dZ
K
2 2
(18)
Notice that marginal value of cash is VW(s) (K , W ) = vs (w ), the marginal value of capital is
V K (K , W ) = vs (w ) wvs (w ), V KK = w vs (w ) K , VWW = vs (w ) K , and VWK
1 1
= wvs (w ) K . Substituting those terms into Eq. (13), we can
(s ) (s ) 2 (s ) (s ) 1

obtain the following ordinary differential equation (ODE) for vs (w ) :

0
1
= i r vs (w ) + ( s Mps )2 + ( K w)
2 2 K S Mpsw vs (w ) + r + i w+ 1 s µA + bi s
2

Mp i gs i, b vs (w )
(19)

where gs (i , b) = 2 (1 1
+ 2 b)2 (1 s) i2 2
b2si2 .
Simplifying the fist-order condition Eq. (14), we obtain the total investment-capital ratio is (w ) equation as follows:

1 vs (w )
i s (w ) = + bMp b, s w 1
vs (w ) (20)
In payout region, W W : Since the continuity of the firm value before and after payout, the firm value-capital ratio vs (w ) satisfies
the value-matching condition: vs (w ) = vs (w ) + (w w ) . Using the smooth-pasting condition and limit property, we obtain the fol-
lowing two conditions of the endogenous upper boundary w = K :
W

vs (w ) = 1, (21)

vs (w ) = 0, (22)

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Z. Shuangling, et al. North American Journal of Economics and Finance 50 (2019) 100991

In liquidation region, W W : Although the firm can execute the liquidation option at any time, intuitively it is optimal for the
firm to wait until it exhausts cash, that is to say, the endogenous lower boundary w = K = 0 . The firm value of liquidation is
W

V (0, K ) = vs (0) K = l (1 s ) K , then

( S )

vs (0) = l (1 s) (23)

3.2. Equity issuance case

The internal financing (W < W < W ) and payout regions (W W ) for the equity issuance case are similar to those given in the
liquidation case in Section 3.1.
In the equity issuance region, W < W : When the firm exhausts its cash and its going-concern value is higher than liquidation
value, the corporate managers would choose to issue equity. h denotes the equity issue amount. According to the value-matching and
smooth-pasting conditions for w , we can obtain the following two equations:
vs (w ) = vs (h) (1 + )(h w) (24)

vs (h) = 1 + (25)

How do the firm managers determine the boundary of equity issuance, w ? We choose the same method used in Bolton, Chen, and
Wang (2013). If w > 0 , we can obtain the optimality condition as follows

vs (w ) = 1 + (26)

However, if Eq. (26) fails to hold, that implies that the firm would not choose to issues equity until it runs out of cash holdings,
i.e., w = 0 .

3.3. Credit line case

In practice, credit debt is also a significant alternative source of cash. Myers, Majluf, and Nicholas (1984) have demonstrated that
because of agency costs and tax effects, debt financing is cheaper than equity financing. Let c (K S ) denote the credit line, which is
proportional to the firm’s physical capital (K S ), and c > 0 . Once the firm decides to increase the credit debt, it would pay a spread
over the current risk-free rate. Intuitively, if the spread of interest rate, , is not too large, the firm prefers to choose credit rather
than issuing equity, which will spend high external financing costs. The internal financing (W < W < W ) and payout regions
(W W ) for the credit line case are similar to those given in the liquidation case in Section 3.1. When the firm selects credit line as
the financing source (w < 0 ), the firm value-capital ratio vs (w ) satisfies the following ODE:

1
0= i r vs (w ) + ( s Mps )2 + ( K w)
2 2 K S Mpsw vs (w ) + r+ + i w+ 1 s µA + bi s Mp i gs i , b vs (w )
2
(27)
Next, when the firm’s cash becomes the marginal source of funds (w > 0 ), the firm value-capital ratio vs (w ) satisfies the ODE (19). If
the firm exhausts its credit line, and its going-concern value is high, it would continue to issue equity. We can obtain the following
two boundary conditions:
vs ( c (1 s )) = vs (h) (1 + )(h + c (1 s )) (28)

vs (h) = 1 + (29)

4. Quantitative results

We now clarify the numerical solutions of the model for given parameters. In the benchmark case, the risk-free rate is set to
r = 6%. The depreciation rate of total capital is = 10%. The obsolescence rate of R&D stocks is = 34% in line with the estimates
provided by Warusawitharana (2015). The mean of physical productivity shock is set to µ = 18%. The physical adjustment cost
parameter is set to 1 = 1.5 (as suggested in Whited (1992)). The R&D adjustment cost parameter is 2 = 2.4 based on the estimates in
Warusawitharana (2015). We nextly set the volatilities of total capital and R&D capital to K = 0.09 and S = 0.8, respectively. The
carrying cost parameter is = 1%. The credit line spread over r is set to = 1.5% (see Sufi, 2009). We set the proportional financing
cost to = 6% in line with the estimates in Altinkilic and Hansen (2000). The fixed financing cost parameter is = 1%. In the
liquidation case, we take l = 0.9 (see Hennessy & Toni, 2007). The ratio of R&D stock to total assets is around 17.9%
(Warusawitharana, 2015). The key variables and parameters of our model are all summarized in Table 1.
This table illustrates the symbols of the key variables and the parameter values in the model. For the upper-case variables (except
K, A, B, M and G) in the left column, their corresponding lower-case variables are used to denote the ratio of the upper-case variable
to total capital, which are in terms of the cash-capital ratio wt .

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Z. Shuangling, et al. North American Journal of Economics and Finance 50 (2019) 100991

Table 1
The key variables and parameters of the model.
Variable Symbol Parameter Symbol Value

Total capital stock K Risk-free rate r 6%

R&D stock S Total capital depreciation rate 10%
Cash holding W R&D capital obsolescence rate 34%
Total investment I Mean physical productivity shock µA 18%
R&D investment B Proportional financing cost 6%
Physical productivity shock A Current technology level G 0.08
Physical investment adjustment cost 1 Physical adjustment cost parameter 1 1.5
R&D investment adjustment cost 2 R&D adjustment cost parameter 2 2.4
Cumulative operating profit Y Proportional cash-carrying cost 1%
Cumulative external financing H Volatility of total capital K 0.09
Cumulative external financing cost X Volatility of R&D stock S 0.6
Cumulative payout U Capital liquidation value l 0.9
Firm value V Per unit R&D profit M 0.9
R&D investment-capital ratio b Fixed financing cost 1%
Ratio of R&D investment to total investment b Autocorrelation of R&D to assets 0.6
Average q qa Ratio of R&D stock to total assets s 17.9%
Marginal q qm Credit line limit c 0.2
Payout boundary w Credit line spread over r 1.5%
Financing boundary w
Target cash-capital ratio h
Success probability p

4.1. Liquidation case

We first analyze the special liquidation case. Fig. 1 depicts the firm value-capital ratio v (w ) , total investment-capital ratio i (w ),
and R&D investment-capital ratio b (w ) as well as their sensitivities (v (w ), i (w ) and b (w ) ) with respect to cash-capital ratio w, for
two cases with liquidation value l = 0.9 and 0.6. When the corporate cash holding w is low, Liquidation option is deeply in the
money, the different liquidation value has a significantly impact on the firm’s decision and value, yet when the firm’s liquidity is high,
that implies that liquidation option is out of the money, so the influence of various liquidation values at that period is negligible.
In Panel A of Fig. 1, the firm value-capital ratio v (w ) starts at l (1 s ) = 0.74 in the case with l = 0.9 (or l (1 s ) = 0.49 with
l = 0.6) when the firm’s cash holding is equal to zero. And it displays a concavity in the region from zero to the payout endogenous
boundary w = 0.275 (or w = 0.307), and a linear function with slope one in the region w w (i.e., beyond the payout boundary).
Intuitively, the firm with smaller liquidation value has a lower firm value, which would choose to delay the payout in order to
accumulate more wealth. In Panel B, when the firm’s financing constraints become stronger or liquidation becomes more likely, the
marginal value of cash will increase sharply. Meanwhile, the concavity of the firm value-capital ratio function in the internal region is
confirmed again. Note that in the case l = 0.9 the marginal value of cash v (w ) reaches a value of 3.94 as cash-capital ratio w
approaches zero, which is because more cash holding will help to keep the corporation away from expensive liquidation. When
l = 0.6, the marginal value v (0) = 7.2 is larger than 3.94. That is to say, in the period with extreme financing friction, cash is more
significant for the firm with a lower liquidation value, which gives rise to the higher marginal value of cash. This figure plots the firm
value-capital ratio, total investment-capital ratio and R&D investment-capital ratio as well as their sensitivities with respect to the
cash-capital ratio w, for two cases with liquidation value l = 0.9 and l = 0.6.
In Panel C, when the firm’s cash holding w is low enough, in order to avoid liquidation, the firm will decide to sell some capital to
increase the amount of cash holding. Due to the under-investment problem and the adjustment costs incurred by lowering capital
stocks, disinvestment is excessively costly. In Panel D, i (w ) is non-monotonic in cash-capital ratio w. In particular, when the cash is
extremely low, i (w ) experiences an apparent increase with the cash-capital ratio w. The last two panels present how R&D investment-
capital ratio b (w ) as well as its corresponding sensitivity b (w ) change with the cash-capital ratio w. In the case with l = 0.9, when the
cash holding w gets close to zero, the value of R&D investment-capital ratio b (w ) approaches −0.45, implying over 45% of R&D
stocks would be sold in order to avoid liquidation. And the R&D investment-capital ratio b (w ) increases significantly with cash-
capital ratio w then flattens out at 5%. Intuitively, due to the highly uncertain returns of R&D, the firm would not choose the high R&
D investment proportion.

4.2. External equity case

In this part, we analyze the more general situation in which the firm will choose to issue equity, when it exhausts its cash holding
and its internally generated liquidity fails to cover the operating costs. Fig. 2 plots the firm value-capital ratio, total investment-
capital ratio and R&D investment-capital ratio as well as their sensitivities with respect to the cash-capital ratio w, for two cases with
fixed financing costs = 1%and = 0.
In Panel A, observe that when exhausting its cash i.e., w =0, the firm value-capital ratio v (0) = 1.13 ( = 1%) is extremely larger

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Z. Shuangling, et al. North American Journal of Economics and Finance 50 (2019) 100991

Fig. 1. Liquidation case.

than liquidation value l (1 s ) = 0.74, so that under our model parameter setting, the firm would rather select external equity
financing than liquidation. Facing external financing costs, the firm optimally decides to issue equity until exhausting cash, i.e., the
external financing boundary w = 0. Compared with the case of liquidation, the payout boundary of the external equity case is
obtained endogenously w = 0.259 with = 1%, relatively lower than the payout boundary in the case of liquidation (i.e., w = 0.275
(l = 0.9) or 0.307 (l = 0.6)). Intuitively, facing quite extreme financing constraint, there are great possibilities to force the firm to
liquidate, thus the firm prefers to hold more cash holdings and defer payout. The firm’s optimal amount of equity issuance (i.e., target
cash-capital ratio) is h = 0.186. In addition, the payout boundary without fixed costs ( = 0) declines further to w = 0.178 and the
target cash-capital ratio h also drops from 0.186 to 0.121. Further, the higher the external equity financing cost , the lower firm
value-capital ratio v (w ) .
Panel B of Fig. 2 shows that the marginal value of cash v (w ) is monotonically decreasing between zero and payout boundary w ,
implying that in this case the firm value-capital ratio v (w ) is strictly concave. When the firm decides to issue equity, the optimal
target cash-capital ratio h must satisfy the condition (26) that the marginal value of cash v (h) equals the marginal cost of external
equity financing 1+ , which also illustrates that the marginal value of cash is increased by the fixed costs of external equity
financing. When the firm exhausts its cash, the cash marginal value v (w ) is around 4.32, much larger than 1.87 in the case with
= 0 . The results highlight the fact that the marginal value of cash is substantially raised by even a moderate fixed financing costs in
the low-cash region. This figure plots the firm value-capital ratio, total investment-capital ratio and R&D investment-capital ratio as
well as their sensitivities with respect to the cash-capital ratio w, for two cases with fixed financing costs = 1% and = 0.
The total investment-capital ratio i (w ) is gradually increasing in w and then flattens out, as shown in Panel C of Fig. 2. Beyond
that, at the payout boundary w = 0.259, the total investment-capital ratio i (w ) = 22.8%. In truth, the high fixed cost of external
equity financing is responsible to the seriousness of financing constraints, which resulting in under-investment issues. In the last two
panels, R&D investment-capital ratio b (w ) first gradually increases with cash-capital ratio w in the low-liquidity region then flattens
out around 4.9% as w exceeds 0.315. In addition, the firm R&D investment proportion is 21.5%, which equals the balanced R&D
investment-capital ratio (4.9%) divides the total investment-capital ratio (22.8%). Interestingly, a key observation emerging from
Panel F is that the R&D investment-cash sensitivity b (w ) is non-monotonic in w, implying the non-concavity of b (w ) in w. That is to

8
Z. Shuangling, et al. North American Journal of Economics and Finance 50 (2019) 100991

Fig. 2. Refinancing case.

say, R&D investment-capital ratio b (w ) is either concave or convex in liquidity w. For example, consider the case with = 0.01, b (w )
first decrease with w then go up and reaches its highest value 2.694 around w = 0.113, and then drops effectively approaching 0 as w
exceeds 0.453. The reason for this seemingly counter-intuitive behavior is that the R&D features of extremely limited mortgage value
and highly uncertainty make the equity finance to became the main source of funds, leading to the more changeable and stronger
sensitivity of R&D.

4.3. Credit line case

Fig. 3 presents the influences of the credit line. Panel A shows that since accessing to the credit line can lower the cost of
financing, the firm value-capital ratio v (w ) with a credit line is increased. The corporate cash reserves significantly reduce when the
firm decides to get a credit: the payout boundary w decreases from 0.256 to 0.189 as the credit line rises from c = 0 to c = 0.2. In the
case without a credit line, i.e., c = 0, the firm exhausting its cash chooses to issue h = 0.121 per unit of capital. Finally, consider the
case with c = 0.2, the marginal value of cash v (w ) in Panel B is 1.06 at w = 0, which is impressively lower than v (0) = 1.56 with the
case c = 0. Intuitively, the credit line can effectively remit the problem of financing constraint.
This figure plots the firm value-capital ratio, total investment-capital ratio and R&D investment-capital ratio as well as their
sensitivities with respect to the cash-capital ratio w, for two cases with the credit line c = 0.2 and c = 0.
Panel C of Fig. 3 illustrates that the firm’s under-investment issue can also greatly mitigated by using the credit line. Consider the
case with credit line c = 0.2, when w approaches zero, the total investment-capital ratio i (0) = 0.167 is significantly larger than
i (0) = -0.439 in the case with c = 0. Beyond that, accessing to the credit line also significantly lower the total investment-cash
sensitivity i (w ) (see Panel D of Fig. 3). For instance, i (0) falls from 3.861 to 0.913 as the credit line increases from 0 to 0.2. In the
fifth and sixth Panels, the firm’s R&D investment-capital ratio b (w ) is gradually increasing in w then flattens out at 4.8% around
w = 0.131. Besides, the value w = 0.131 is slightly larger than w = 0.112 at which the i (w ) gets the highest and balance point 22.4%.

9
Z. Shuangling, et al. North American Journal of Economics and Finance 50 (2019) 100991

Fig. 3. Credit line case.

Intuitively, due to the highly uncertain returns of R&D, the firm will prefer to reserve more cash. Meanwhile, we can again get the R&
D investment proportion is 21.4%.

4.4. Tobin’s average q and marginal q

In this section, we now focus on the model’s predictions for Tobin’s average q and marginal q. The firm’s enterprise value (i.e., the
value of the corporate capital stock) is equal to the firm value minuses cash holdings, V (K , W ) W . Next, we denote average q and
marginal q by qa (w ) and qm (w ) , respectively. Then, the qa (w ) and qm (w ) can be obtained as follows:
V (K , W ) W
qa (w ) = = v (w ) w.
K (30)

d (V (K , W ) W)
qm (w ) = = v (w ) wv (w ) = qa (w ) v (w ) 1 w.
dK (31)

Due to v (w ) 1 and v (w ) < 0 , both qa (w ) = v (w ) 1 and qa (w ) = v (w ) equations highlight that average q is monotonically
increasing and concave in w. Further, consider the wedge between qa (w ) and qm (w ), (v (w ) 1) w , when v (w ) > 1 and w > 0 , the
wedge is positive, that is to say, average q is larger than marginal q. However, in the credit region, because of v (w ) > 1 and
w < 0, qm (w ) is greater than qa (w ) . Specially, under MM (Modigliani & Miller, 1958), v (w ) = 1, implying qa (w ) = qm (w ) .
Fig. 4 presents the Tobin’s average q and marginal q for liquidation cases (l = 0.9, 0.6), external equity cases ( = 1%, 0), and
credit cases (c = 0.2, 0). In the first two panels, when the cash is very low, liquidation option is deeply in the money. We can see that
the larger the liquidation value, the higher the firm value, and thus both average q and marginal q (with l =0.9) are impressively

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Z. Shuangling, et al. North American Journal of Economics and Finance 50 (2019) 100991

Fig. 4. Average q and marginal q. This figure plots the Tobin’s average q and marginal q for liquidation cases (l = 0.9, 0.6), external equity cases
( = 1%, 0), and credit cases (c = 0.2, 0).

greater than those in the case with l = 0.6, respectively. Panels C and D report the effect of changes in the fixed financing costs on the
Tobin’s average q and marginal q. Consistent with the essential economic intuition, it is easier for the firm without fixed financing
costs ( = 0) to enter the equity market and issue equity, thereby the average and marginal q are relatively higher than those in the
case with = 1%, respectively. In Panels E and F of Fig. 4, in both credit (w < 0 ) and cash (w > 0 ) regions, we can see that average q
is gradually increasing with the cash-capital ratio w, and the firm’s Tobin’s average q is still monotonically increasing and concave in
w. However, the firm’s marginal q is non-monotonic in w. The marginal source of financing (cash or credit, i.e., w > 0 or w < 0 ) plays
a key effect on the relationship between marginal q and w. Specifically, in the credit region marginal q decreases in w, but it increases
in w in the cash region.

4.5. The R&D capital stock ratio s

In our model, the physical investment equals to the total investment minus the R&D investment, i.e.,I-B. We define the rate of the
physical investment is d (w ) . Fig. 5 depicts when the external financing cost is = 1%, the change of the physical investment-capital
ratio d (w ) , and R&D investment-capital ratio b (w ) as well as their sensitivities (d (w ) and b (w ) ) with respect to cash-capital ratio
w, here, we consider three cases with R&D capital ratio stock s = 0.1, s = 0.2 , and s = 0.3. This figure plots the effects of the different
R&D capital stock ratio (s = 0.1, s = 0.2, and s = 0.3) on the physical investment-capital ratio d (w ) , and R&D investment-capital
ratio b (w ) , physical investment-cash sensitivity d (w ) , and R&D investment-cash sensitivity b (w ) .
When the firm face external financing costs, it is optimal for them to hoard cash for precautionary reasons. In our model, while it
is still a key reason that the firm saves, the stochastic R&D investment opportunities introduce an additional motive for the firm to
issue equity when w is close to the lower barrier W , which causes the firm physical investment-capital to become locally convex in w.
In other words, the firm becomes endogenously risk-loving when the market timing option is more in the money near the equity
issuance boundary, as shown in the panel A. Of course, with the increase of s, R&D investment-capital ratio also increases. By the

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Z. Shuangling, et al. North American Journal of Economics and Finance 50 (2019) 100991

Fig. 5. The R&D capital stock ratio changes.

definition of the variable s, we know that the larger the value of s, the more the intangible assets there are, hence, the higher the
technical level. When the technical level is very lower, i.e., the variable s = 0.1, from the panel A and panel B, we can see the firm
with lower technical level prefers to physical investment. When the technical level is very higher, i.e., the variable s = 0.3, from the
panel A and panel B, we can see d (w ) is stabilizing at 12.2%, which is less than 16.9% (s = 0.1) and b (w ) is stabilizing at 27.9%,
which is much higher than 4.8% (s = 0.1). Hence, we can draw that with higher technical level prefers to R&D investment. In
addition, in the area of low cash flow, the firm will choose to reduce physical investment and increase the relative proportion of R&D
investment in order to occupy the market share, obtain monopoly profit and the market competitiveness. From panel C and panel D,
we can see the R&D investment is more sensitive than physical investment because of the highly uncertainty of the R&D investment
return and the time.

5. Comparative static analysis

Next, we study the effects of changes in the obsolescence rate , the R&D adjustment cost parameter 2, and the volatility of R&D
stocks S on the firm value-capital ratio v (w ) and the marginal value of cash v (w ) , respectively.

5.1. The effect of changes in the obsolescence rate of R&D

Warusawitharana (2015) has demonstrated that the R&D returns based on the production function regression tend to vary
substantially with the assumed obsolescence rate of R&D. In addition, it is very difficult to determine the obsolescence rate of R&D:
first, in addition to depending on the progress of public research and science, it is also determined endogenously by the behaviors of
both the firm and its competitors; second, due to the nature of competition, it varies across the industrial sectors. Although the
obsolescence rate of R&D usually (but not always) vary slowly in the time dimension, it is not perfectly rational and accurate to
assume that rate is constant over time and across firms, which also illustrates the reason why literature lacks of powerful evidences
on the reasonable value for . Fig. 6 shows the effect of changes in the obsolescence rate of R&D, = 0.15, 0.25 and 0.35, on the firm
value-capital ratio v (w ) and the marginal value of cash v (w ) . For example, in the relatively high liquidity region, consider the case
with w = 0.4, the firm value-capital rate v (w ) decreases slightly around 0.033 as varies from 0.15 to 0.25, and v (w ) decreases
sharply about 0.127 when again increases from 0.25 to 0.35. Therefore, the firm value changes sharply with the obsolescence rate
of R&D.

5.2. The effect of changes in the R&D adjustment costs parameter

R&D expenditures are not only similar to but also different from physical investment. More than half of R&D spending is spent on

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Z. Shuangling, et al. North American Journal of Economics and Finance 50 (2019) 100991

Fig. 6. The effect of changes in obsolescence rate .

the salary of highly trained engineers and scientists (Hall, 1992, 2002), so the adjustment cost of R&D investment is obviously greater
than that of physical investment. However, there is only limited literature to estimate the approximately adjustment cost of R&D
investment. Fig. 7 shows the effects of changes in R&D adjustment cost parameter, 2 = 2.4, 3 and 5, on the firm value-capital ratio
v (w ) and the marginal value of cash v (w ) . As the R&D adjustment costs parameter 2 increases, both the firm value-capital ratio v (w )
and the marginal value of cash v (w ) are decrease slightly. Interestingly, when 2 grows from 2.4 to 3, the Panel A shows a significant
decrease of the firm value-capital ratio v (w ) , but when 2 increases from 3 to 5, we just see a slightly decline of v (w ) . Intuitively, when
a firm decides to increase the R&D investment, the larger the R&D adjustment costs, the smaller the firm value. However, once the R&
D adjustment costs are too high, the firm will reduce the R&D investment ratio and turn to increase the physical investment, leading
to the very little effect of the R&D adjustment costs parameter 2 on v (w ) .

5.3. The effect of changes in the volatility of R&D stocks

Since the R&D assets are intangible stocks, the level of R&D uncertainty returns is extremely larger than that of physical in-
vestment, besides, to some extent because of also depending on the actions of their competitors and little secondary use value in the
ongoing firm, the volatility of R&D asset accumulation can be very high. Fig. 8 plots the effect of changes in the volatility of R&D,
S = 0.4, 0.6 and 0.8, on the firm value-capital ratio v (w ) and the marginal value of cash v (w ) . To conclude, as the volatility of R&D
stocks S rises, v (w ) declines and v (w ) increases. For instance, as S increases from 0.4 to 0.6 and then from 0.6 to 0.8, when
w = 0.048, the firm value-capital ratio decreases from 0.837 to 0.820 and then from 0.820 to 0.775, beyond that, the marginal value
of cash increases from 1.019 to 1.074 and then 1.074 to 1.567.

6. Simulation

In this section, we will mainly use the solution of the model above and conduct simulation based on Brownian Z motion

Fig. 7. The effect of changes in the R&D adjustment cost parameter 2.

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Z. Shuangling, et al. North American Journal of Economics and Finance 50 (2019) 100991

Fig. 8. The effect of changes in the volatility of R&D stocks S.

Fig. 9. Simulation path.

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Z. Shuangling, et al. North American Journal of Economics and Finance 50 (2019) 100991

path.Fig. 9 shows the three simulation routes of total capital stock K, R&D capital stock S, liquidity wealth capital stock ratio w, firm
value capital ratio v, physical investment capital ratio d, and R&D investment capital ratio b . From the panel A, we can see that the
total capital stock K increases gradually over time. Form the panel B, due to the high obsolescence rate of R&D, the R&D capital stock
showed a declining trend in the first seven years, once the R&D project was successful in the seventh year, the R&D capital showed a
sharp increase in the following years(as shown by the black line in the subgraph B). However, if R&D project failed, the R&D capital
stock continued to decline (e.g. Red lines in subgraph B). As the company continued to adjust its financing, investment, dividend
payout or the other strategies, we can see the liquidity wealth capital ratio w kept changing from the panel C. The panels E and F show
the three simulation routes of physical investment capital ratio d and R&D investment capital ratio b . In the general case, d is about
18%, and b is about 5%. In particular, the firm may choose to sell capital when the firm are faced with strong financing constrains or
serious shortage of liquidity wealth. For example, in the fifth year, the firm sold 21 percent of their pyhsical capital and 5.3 percent of
R&D capital to increase cash holding. This figure plots the three simulation routes of total capital stock K, R&D capital stock S,
liquidity wealth capital stock ratio w, firm value capital ratio v, physical investment capital ratio d, and R&D investment capital ratio
b.

7. Conclusion

In recent years, the competitive advantage of R&D innovation is growing sharply, however in very little literature, the intangible
and tangible investment in the field of dynamic corporate finance are distinguished. In addition, the research methods on intangible R
&D investment are mainly the empirical regression model and the dynamic discrete model based on the production function. In this
paper, we propose a dynamic continuous model for corporate intangible and tangible investment, risk management and financing,
when firms face stochastic R&D stocks and financing conditions. In our research, we first make a dynamic model for a financially
constrained firm about R&D and physical investment, financing and risk management, and then analyze the market-timing decisions
for the corporate liquidation, external equity, credit debet, and payout. And the comparative static analysis about R&D is given. We
find that the firm value is sensitive to the different values of the obsolescence rate of R&D, and R&D investment is more im-
pressionable to financing frictions than physical investment. Our model and analysis provide the new insight into the investment and
financing of intangible capital. Beyond that, there exists a policy of using the tax to subsidize R&D investment, and the success of an
innovation can bring lots of patent returns. However, this article does not involve the tax policy and patent protection policy, which
need to be contained in the future research.

Fund

This research was supported by the Youth Science Fund of the National Natural Science Foundation of China (Grant No.
61802149) and the Fundamental Research Funds for the Central Universities (Grant No. 21618315).

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