Fabrizio Adriani (University of Leicester)

In a model with financial frictions, we study firms’ decision to invest in R&D (innova-tion) and/or in more effective management (rationalisation). We model management as a technology in the spirit of Bloom et al. (2017). So long as debt and equity are equally mispriced, financial frictions affect both these intangibles in the same way through standard average cost of capital effects. In contrast, in the presence of asymmetric frictions, investments in innovation and rationalisation behave very differently. In particular, R&D is exclusively sensitive to equity mispricing, while management investment and debt are complements. This has far reaching implications. For instance, the burst of a stock market bubble may induce firms to cut R&D, replace equity with debt and, at the same time, increase investment aimed at rationalising production. More generally, we establish the existence of a capital structure channel through which financial frictions determine what types of intangibles firms prioritise. These observations may help to explain some stylised facts about debt-induced rationalisation waves in the 80s and R&D booms in the 90s.

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