This paper examines the effect of product innovation on capital structure choice in the context of corporate governance, net leverage trade-offs, and firm size. A simultaneous model of product innovation and capital structure is specified and
estimated with a three-stage least squares methodology to control for cross-equation correlation of error terms. The results
suggest that product innovation is an important determinant of capital structure choice, and that the exact relationship between capital structure and asset specificity depends crucially on the firm size class. For small firms, product innovation coincides with greater levels of debt financing. For large firms a
negative relationship between debt/equity and innovations is found.
The small-firm results are consistent with both the pecking order and leverage trade-off theories. Small firm innovation is positively related to internal cash flow. For small firms that utilize external financing, the net tax effect exceeds the sum of all other leverage related costs, leading to a positive
relationship between innovation and debt in the capital
structure. For large firms, the results are also consistent with the trade-off theory, however, the net tax effect does not exceed other leverage related costs. The large firm findings are also consistent with the governance approach to capital structure.
Innovative firms, whose assets are more unique, use greater
portions of equity in their capital structure.
Because of the similarity between the TCE and agency approaches to corporate finance, it is not unreasonable to conclude that structural differences in agency cost structure affect the efficiency of the corporate governance as it is
applied to the capital structure of small and large firms. It is evident from these empirical findings the TCE in more vital for large firms rather than small firms.
The findings of this study indicate that innovation is a more complete measure of asset uniqueness and firm growth
potential than R&D for large firms. Whereas R&D is intangible, innovation provides a tangible measure of asset specificity.
Future research will have to examine the extent to which the strategies of small innovative firms have been successful by comparing small innovative firms that are actively traded with those that were either the targets of takeovers or went bankrupt.
36
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