Regional Financial Developments and Research and Development Investment–Cash Flow Sensitivity: Evidence on Chinese Public High‐Tech Companies

• Date: 01 December 2017
• Author: Feifei Zhu,Jie Hu,Guo Li
• DOI: http://doi.org/10.1111/irfi.12122
• Published date: 01 December 2017

Regional Financial Developments

and Research and Development

Investment–Cash Flow Sensitivity:

Evidence on Chinese Public

High-Tech Companies

JIE HU

†

,GUO LI

‡

AND FEIFEI ZHU

§

†

Department of Finance, International Business School, Shaanxi Normal University,

Xi’an, Shaanxi, China,

‡

Economic and Strategic Research, Fannie Mae, Washington, DC, USA and

§

Department of Accounting, Finance and Business Law, College of Business and

Economics, Radford University, Radford, VA, USA

ABSTRACT

In a sample of 485 Chinese public high-tech companies, we show that the

R&D investment is significantly dependent on internal cash flow. Based on

the sizable discrepancies of stock market and financial intermediary develop-

ments in the East, Middle and West regions of China, empirical estimation

provides strong evidence that the financial developments in both credit and

equity markets have large effects on reducing financing constraints. The effects

are most significant in the financially advanced East region of China.

JEL Codes: G14; G31; G32; G38

I. INTRODUCTION

For nearly three decades, China’s economy is highly dependent on manufactur-

ing and exports. China has made a shift to move up the manufacturing value

chain by boosting innovation and technology as key drivers of its economy.

Since 2004, China initiated “Small and Medium Enterprise Board”and “Growth

Enterprise Market”to provide more financing opportunities for high technology

companies, which are mostly financially constrained but have great growth po-

tentials. However, little empirical evidence has been provided to examine

whether such financial developments that supposedly open up more financing

channels actually reduce/remove the financial constraints. This paper attempts

to address this issue by examining the impact of financial market developments

on investment–cash flow sensitivity.

In this study, we specifically focus on the publicly listed high-tech compa-

nies in China, where the most investments are in the form of research and

© 2017 International Review of Finance Ltd. 2017

International Review of Finance, 2017

DOI: 10.1111/irfi.12122

International Review of Finance, 17:4, 2017: pp. 627–643

DOI: 10.1111/irfi .12122

© 2017 International Review of Finance Ltd. 2017

development.

1

These high-tech firms are often characterized with high infor-

mation asymmetry, which precludes outsiders from making accurate appraisals

of value and leads to higher cost of equity. The similar problem can also affect

firms’access to the debt market because of the asymmetric information on risk

characteristics and default probabilities. The problems are further compounded

by the lack of collateral value for R&D investment and possible moral hazard

(Arrow 1962). Given the abovementioned limitations for the public high-tech

companies to obtain external financing, they are more likely to demonstrate

high investment–cash flow sensitivity.

Previous literature has recognized that external financing can be expensive for

some firms, areas or countries due to different levels of capital market imperfec-

tion and cost of information. Developments in the financial sectors, however,

offset this friction by increasing firms’access to external finance. Empirically,this

is recognized in several prominent papers: King and Levine (1993), Rousseau and

Wachtel (1998), Rajan and Zingales (1998), Demirgüç-Kunt and Maksimovic

(1998), Neusser and Kugler (1998), Beck et al. (2005), and Khan and Semlali

(2000). All of them provide cross-country or cross-industry evidence that the

financial developments impact growth positively, by reducing financial

constraints or frictions that hinder the efficient allocations of investment

resources.

Within this broad literature, some studies focus on the micro-level decision

making and analyze the effect of firms’financial wellness on investment (see

Hubbard 1998 and Hall and Lerner 2010 for the most recent surveys on this is-

sue). In general, studies agree that due to moral hazard and adverse selection in

both equity and debt markets, firms find it necessary to finance their invest-

ment internally.

2

The financing constraints are especially notable in the high-

tech industry, due to return uncertainty, substantial information asymmetries

and limited collateral value (Carpenter and Petersen 2002 and Beck and

Demirgüç-Kunt 2006). Furthermore, a large portion of R&D investment in-

volves salary payments, causing high adjustment costs that deteriorate the

agency problem (Himmelberg and Petersen 1994). A recent paper by Wang

(2013) summarizes the channels through which institutions might affect pri-

vate enterprises’ability to finance R&D. The development of regional loan mar-

ket can increase the return on R&D by helping entrepreneurs bring strong ideas

to the market, and facilitate the hiring of highly trained individuals. The stock

market development (STK) avails firms to trade ownership without interrupting

the current R&D process. It also allows agents to diversify their portfolios.

3

In-

deed, small enterprises are the engines of economic innovations, but if institu-

tional factors impede their growths government interventions should be

suggested.

1 The start-up high-tech companies are not included in our sample, which often finance their

projects through private equity.

2 Also referred to as “financing hierarchy”as in Myers and Majluf (1984).

3 These findings are also confirmed in Levine (1991) and King and Levine (1993).

International Review of Finance

© 2017 International Review of Finance Ltd. 20172

International Review of Finance

628 © 2017 International Review of Finance Ltd. 2017