Topic: Financial Structure and Oligopoly: The R&D Effect

Lecturer: Assistant Professor, Victor Song, Simon Fraser University Beedie Business School

Time: 11:00-12:00 a.m. November 9th, 2023

Venue: B336 Zhixin Building, Central Campus

Abstract: Financial structure is an important decision variable for firms, and varies significantly across industries. Capital intensive industries such as manufacturing or utilities, which have substantial physical assets and typically generate stable cash flows, tend to have relatively high debt-equity ratios. In contrast, research intensive industries, such as those in the "high tech" sector, issue much less debt. Conventional wisdom is that financial distress costs are the most important explanatory factor for this variation in financial structure. That is, firms with more uncertain prospects might seek to minimize the chance of financial distress and the associated costs by keeping debt levels low. However, the high-tech giants with very low debt to equity ratios such as Apple, Google, Microsoft, Amazon, Facebook, and others do not seem vulnerable to financial distress risk. In this paper, we offer an alternative theory to explain why financial structure varies across industries. We focus on the relationship between financial structure and R&D in an oligopoly context. There are two distinct types of R&D -- process R&D, which lowers the cost of producing a given product, and product R&D, which changes product characteristics and/or improves product quality. Our key insight is that process R&D is complementary with the strategic use of debt to improve a firm's market position under oligopoly. As in Brander and Lewis (1986), firms have an incentive to use debt to commit themselves to a more aggressive position in the output market. Process R&D strengthens this effect. Product R&D, on the other hand, increases product differentiation, weakens head-to-head competition between oligopolistic rivals, and reduces the incentive to use debt for strategic purposes. As manufacturing industries and utilities make relatively more use of process R&D, while high-tech industries undertake relatively more product R&D, we can explain why the high-tech industries make relatively less use of debt and have much lower debt to equity ratios.