increases.
13
On the other hand, if e
x
, 0, increasing investment in intangibles increases effort, which can increase reduce debt cash flows in each insolvent state and reduce
increase the number of these states; hence, increased investment in intangibles could reduce increase the promised debt payment. The decline in B
ˆ as x increases is shown to be associated with effort levels that exceed qf8m, while the increase in B
ˆ with x is associated with levels of effort less than qf8m.
The direct relationship between investment in intangibles and promised debt payment suggests that increased intangible asset investment, working through effort, reduces real
asset value when insolvency strikes; thus, given debt, a higher promised payment is required. The indirect impact of intangibles via effort on real assets is in addition to their
relatively lower value in bankruptcy. This value reduction in bankruptcy has been used in the literature to explain why intangibles support less debt than real assets. However, our
focus is on the effect of intangibles on debt repayment for a given level of debt. More importantly, Proposition 2 shows that investment in intangibles and promised debt
repayment could be inversely related. This occurs when increased investment in intangi- bles induces the manager to increase effort, i.e., e
x
, 0, in an attempt to avoid bankruptcy and the resulting loss of the intangibles’ expected cash flows. Stepped up effort increases
the value of current production assets to bondholders in all states, including insolvency states, thus reducing B
ˆ . Alternatively, increased investment in intangibles increases the collateral value of current production assets to bondholders indirectly via effort. This
collateral-like aspect of intangibles has not been examined in the literature and, as Proposition 2 indicates, is present at sufficiently high levels of risky debt, i.e., B[B
2
, B ,
but is absent for sufficiently low levels of risky debt, i.e., B[B, B
1
.
V. The Investment Problem
Given the exogenous level of debt which is priced as shown in the previous section, the manager decides on the investment in current production, x, and in intangibles, 1 2 x,
recognizing that, subsequently, effort will be chosen optimally. In choosing optimal investment in current production, x, the manager maximizes the firm’s net present value,
V, which is given by
14
Max
x[0, 1
V ;
E
p
1
p
pC 1 E~pC 1 E~qD dF~p 1
E
p
1
~ pC 1 D dF~p 2 1. 6
Firm value equals the sum of the expected cash flows when the firm continues as a going concern, i.e., p[[ p
1
, p], and the expected cash flows when it liquidates, i.e., p[[0, p
1
, minus total investment.
The first order condition for equation 6 is given in the Appendix. It requires that x be increased until the firm’s overall cash flow associated with marginal investment in current
production vanishes. The intuition is straightforward. The owner’s objective is to allocate fixed investment funds between current investment and intangibles; hence, the cost of
shifting more resources to current production is zero at the margin, as it does not entail
13
p
2
x 5 2B ˆ e 1 xe
x
ux
2
e
2
, 0, while pC 1 Dx 5 up 1 pd2e 1 xe
x
. 0, p[[0, p
2
.
14
Given that, in equilibrium, the debt market correctly anticipates the manager’s actions, this is equivalent to maximizing the equity value. We assume that the second order condition for an interior maximum is satisfied.
10 M. H. Anderson and A. P. Prezas
raising additional funds. On the other hand, changing x affects the firm’s overall expected cash flows both directly and indirectly; the latter through effort and the probability of
solvency.
15
Nevertheless, the effect of x on overall cash flow depends on debt financing, implying that the optimal allocation changes with debt. Specifically, an exogenous change in debt,
B, causes optimal investment in current production to change by: dx
dB 5
dx dB
ˆ dB
ˆ dB
. 7
This indicates that increasing debt affects optimal current investment only through its effect on promised debt repayment. Because promised repayment increases with debt, it
follows from equation 7 that the relationship between debt and optimal investment depends on that between the required debt repayment and optimal investment.
As indicated above, resources are shifted to current production until the overall cash flows associated with marginal investment vanish. Increasing debt repayment exog-
enously affects these cash flows both directly, and indirectly through effort. From Proposition 1, optimal effort declines as debt repayment increases. Further, lower effort
increases the firm’s overall cash flows associated with marginal investment in current production see equation A6 in the Appendix. Hence, the indirect effect of higher debt
repayment on optimal investment is positive. On the other hand, the sign of the direct effect of debt repayment on optimal investment depends on that of e
x
see equation A5 in the Appendix. When effort increases with current production investment, the direct
effect is positive, complementing the indirect one, and thus optimal investment in current production increases with debt repayment. However, when effort and investment in
current production are inversely related, the direct effect can be either positive or negative; hence, optimal current production investment could increase or decline, depending on the
relative sizes of the direct and indirect effects. The above discussion is formalized in:
Proposition 3. Ceteris paribus, an increase in the amount of risky debt financing reduces optimal investment in intangibles if effort and investment in intangibles are inversely
related; otherwise, it may increase optimal intangible investment. Proof. See Appendix.
Proposition 3 says that optimal investment in intangibles is inversely related with debt when effort and intangibles are inversely related i.e., e
x
. 0. If effort increases with intangibles i.e., e
x
, 0, however, debt and intangibles could be positively related. Although the inverse relationship is in line with existing literature, e.g., Smith and Watts
1992, the possibility of a positive relationship has not been examined. This latter result is a consequence of Proposition 2, which states that if effort is positively related with
investment in intangibles, increasing intangibles expenditures can lead to lower debt repayment. Alternatively, borrowing more leads to higher investment in intangibles, as the
reduced debt repayment increases the probability that the firm continues as a going concern, realizing the benefits of the intangibles.
15
Effort is a function of x either directly or indirectly via promised debt payment see Sections III and IV. The probability of continuing as a going concern is 1 2 Fp
1
, and depends on x through p
1
either directly or indirectly via e and B
ˆ .
Intangibles, Debt, and Managerial Incentives 11
The possibility of a positive relationship between debt financing and investment in intangibles vanishes, however, when the threat of bankruptcy and the associated loss of
the intangible assets’ cash flows is removed. To see this, we turn to the fully secured debt case.
Fully Secured Debt
Debt is fully secured when the promised debt payment does not exceed the salvage value of current production assets. This implies bondholders will recover their initial t 5 0
outlay regardless of the t 5 1 price realization, i.e., p
2
5 0. As the discount rate is assumed to be zero, it follows that the required repayment will equal the amount borrowed, i.e.,
B ˆ 5 B, if debt does not exceed B, where B is the maximum possible level of fully secured
borrowing and is derived in the Appendix. With these qualifications, the first order condition for equation 2 provides the following closed form solution for optimal effort:
e 5 2pux 1 qf~1 2 x
4m ,
8 and its properties are summarized in:
Proposition 4. Ceteris paribus, when debt is fully secured, optimal effort varies directly with cash flows from either asset as captured by p, q, u or f, inversely with effort
disutility, m, or investment allocation, x, but is independent of the salvage proportion, d, or debt repayment, B
ˆ . Proof. See Appendix.
The intuition for this proposition is similar to that of Proposition 1, with the following exceptions. With fully-secured debt, a reduction in current production increases effort, as
it increases equity cash flows but does not affect the disutility of marginal effort. Further, changing d or B
ˆ affects neither equity cash flows nor disutility of marginal effort; hence, effort is independent of d or B
ˆ . Optimal investment in current production is again determined by solving equation 6.
However, debt repayment is now independent of the investment policy recall B ˆ 5 B,
implying that the indirect effects of allocation x through debt repayment dissipate. Finally, from equation 7, the direct effect of debt on optimal investment is positive,
while, from Proposition 4, the indirect effect is absent, as effort is independent of debt repayment. Hence,
Proposition 5. Ceteris paribus, an increase in the amount of fully-secured debt financing causes optimal investment in intangibles to decrease at a decreasing rate.
Proof. See Appendix.
An extreme case of secured debt arises when borrowings are zero, i.e., B 5 0. When the firm is all equity financed, it cannot be insolvent, but shifting resources to current
production reduces expected cash flows;
16
hence, optimal investment in current produc-
16
Using equation 1 and Proposition 4, this follows from:
x
E
p
pC 1 E~ pC 1 E~q D dF~ p 5 2pu 2 qf
2 e 1 pux 1
1 2
qf~1 2 xe
x
, 0.
12 M. H. Anderson and A. P. Prezas
tion becomes zero. Comparing this with the solution obtained for the maximum level of secured debt implies that borrowing B forces the manager to direct resources away from
intangibles to the lower payoff current production in order to secure debt repayment although this may require liquidation. Hence, as debt jumps from zero to B, x increases.
It then follows from Proposition 4 that, at the same time, the owner’s effort will be reduced. Actually, from equation 8, the first-best effort level, e, occurs when B 5 0,
and is given by:
e 5 qf
4m .
9 In essence, with no need to consider debt repayment, the owner simply invests in the
technology having the greatest net present value; thus, investment is exclusively in intangibles. Likewise, without the distortions associated with debt financing, the owner’s
effort is at its maximum level.
Discussion
Our results have implications for corporate investment in intangible assets like RD. Specifically, our findings demonstrate that the decision about RD investment depends
on the extent to which debt is used to finance total investment, as well as the effort expended in managing the firm. Effort can be proxied, for example, by investment in
industrial processes i.e., process RD. This encompasses activities such as the amount of interdisciplinary teamwork, the feedback between the research department and cus-
tomers or between managers and those on the shop floor, and the development of processes which can quickly transform new RD concepts into final products. Such effort
enhances productivity by improving the manufacturing process and also enables the firm to reap the benefits of being the first to introduce new products.
With effort proxied by investment in such industrial processes, Proposition 3 suggests some cross-sectional predictions. Specifically, consider an industry in which firms have
proportionally high RD expenditures but low investment in industrial processes. Among such firms, we would expect a negative relationship between risky debt and investment in
RD. By contrast, in an industry characterized by high levels of both RD and industrial processes expenditures, the relationship between debt and RD could be reversed. Such
predictions differ from the strictly negative cross-sectional relationship between RD investment and debt documented in Bradley et al. 1984 and Long and Malitz 1983. The
difference arises from the fact that the present paper suggests the need to classify firms by investment in industrial processes i.e., effort in addition to the classification by RD
expenditures. Actually, if effort is not a factor, Proposition 3 suggests a strictly negative relationship between debt and RD similar to that found in the existing empirical
literature.
17
Accounting for effort is important, however, because there is evidence that investment in industrial processes varies widely across industries. For example, Caravatti 1992
indicated that in 1985, the mean percentage of industrial process expenditures to RD expenditures varied from 7.6 for the instruments and related products industry to 150.6 for
17
From the proof of Proposition 3, it follows that the indirect effect of B ˆ on x vanishes, while the direct
effect is strictly positive.
Intangibles, Debt, and Managerial Incentives 13
the petroleum products industry. Additionally, Chauvin and Hirschey 1993 reported that RD spending is unevenly distributed across industries. In the period 1988 –1990, high
RD industries included measuring instruments, electronic equipment, and chemical and allied products. Low RD spending was reported in the financial sector and retailing
industries.
The testable hypothesis suggested above appears to be well-suited to examine the relationship between RD spending and debt among firms grouped by RD and indus-
trial process spending. For instance, we would expect an inverse relationship between RD spending and debt for firms in the instruments industry, which exhibits high RD
but low industrial process spending. On the other hand, the relationship between RD spending and debt for firms in the rubber and plastic products industry, which exhibits low
spending in both RD and industrial processes, cannot a priori be expected to be negative. Consequently, unless differences in industrial process expenditures across firms are
adequately accounted for in empirical tests, it should not be unambiguously concluded that debt and RD are inversely related. Although they did not use process RD as an
explanatory variable, Bhagat and Welch 1995, using international data, found a signif- icant negative positive relation between the last year’s debt ratio and current RD
expenditures for U.S. Japanese firms. This provides indirect empirical support for our hypothesis, as Japanese firms tend to have significantly higher levels of process RD than
U.S. firms [see, e.g., Caravatti 1992].
VI. Conclusion
