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The impact of country-level corporate governance on research and development

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Abstract

We investigate the process through which country-level corporate governance facilitates firm-level investment in research and development (R&D). Taking cash flow as one of the main determinants of R&D, we derive an econometric model that introduces a number of corporate governance factors (legal protection, financial system, and control mechanisms) to analyze their impact on R&D-cash flow sensitivity. Using data from nine European Union countries, Japan, and the United States, we show that R&D at the firm level is less sensitive to internal cash flow in countries with effective investor protection, developed financial systems, and strong corporate control mechanisms. Specifically, our analysis suggests that the characteristics of the corporate governance system that facilitate R&D are a common law legal environment, minority shareholder protection, strong law enforcement, a bank-based financial system, effective board control, and a strong market for corporate control. This evidence points to corporate governance as a key element in R&D investment, and contributes to the debate on whether country-level corporate governance systems can facilitate R&D projects and, indirectly, promote economic growth.

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Notes

  1. The extent to which country-level corporate governance and firm-level governance interact is still uncertain. Collecting firm-level corporate governance information for many of the companies in our sample is difficult, because of differences in the quality of disclosure across countries. However, a relation between country-level and firm-level corporate governance is likely, although whether they act in a complementary fashion or as substitutes is still to be ascertained. Pay-performance sensitivity is an example (for an overview of executive compensation and corporate practices, see Faulkender, Kadyrzhanova, Prabhala, & Senbet, 2010). Given that R&D investment can dampen profitability in the short run, poorly governed firms with short-term sales targets may delay R&D (especially when cash flow is low) to ensure that performance measures are not affected. In such a situation, both the level of R&D and its sensitivity of cash flow will be affected (see Du & Choi, 2010, for the impact of Western pay-performance practices in China, a country with lower levels of development).

  2. We focus on cash flow because of the wealth of research that finds it to be of importance in R&D investment. However, other variables have also been shown to be influential. For example, Brown et al. (2009) and Brown and Petersen (2009) identify external equity as an important driver.

  3. The empirical framework is general enough to allow any number of moderating factors. Although the focus of our study is on country-level corporate governance, other variables, such as accounting standards (e.g., IASB, GAAP, local), political links, and private vs publicly traded status could be considered.

  4. We use long-term debt because most of the arguments in agency theory are related to this type of debt (see, e.g., Miguel & Pindado, 2001).

  5. High ownership concentration is defined as higher than the median percentage of ownership by the three largest shareholders in the 10 largest nonfinancial, privately owned domestic firms.

  6. These countries are Ireland, the Netherlands, the United Kingdom, and the United States. The classification coincides with that of market-based countries, with the exception of Ireland.

  7. To avoid a huge number of dummy variables in the model, we use the most general industrial classification system.

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Acknowledgements

The authors began collaboration on this paper in 2007 while Valdoceu de Queiroz was a visiting scholar at Leeds University Business School, University of Leeds. The authors thank three anonymous referees and the editor, Lemma Senbet, for comments and suggestions on previous versions of this paper. Hillier, Pindado, de Queiroz, and de la Torre are grateful to the Spanish government's research agency, DGI (Project SEJ2007-65789) for financial support. Pindado and de la Torre also recognize the financial support of the Junta de Castilla y Leon (Project SA069A08 and Grant GR144). All errors are the authors’ responsibility.

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Authors and Affiliations

  1. Department of Accounting and Finance, University of Strathclyde, Glasgow, UK

    David Hillier

  2. Department of Business Administration, Universidad de Salamanca, Spain

    Julio Pindado & Chabela de la Torre

  3. National Treasury Secretariat, Ministry of Finance of Brazil,

    Valdoceu de Queiroz

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  1. David Hillier
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  2. Julio Pindado
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  3. Valdoceu de Queiroz
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  4. Chabela de la Torre
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Correspondence to David Hillier.

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Accepted by Lemma Senbet, Area Editor, 30 May 2010. This paper has been with the authors for three revisions.

APPENDIX

APPENDIX

The variables used in our analysis are defined. With the exception of the items that come from the Main Economic Indicators, published by the Organization for Economic Cooperation and Development, we obtain the items used in the construction of our from Worldscope.

Research and Development (R&D)

The R&D variable, RD it , represents all direct and indirect costs related to the creation and development of new processes, techniques, applications, and products with commercial possibilities.

Cash Flow

We compute a firm's cash flow as CF it =NIAPD it +DEP it , where NIAPD it denotes net income after preferred dividends, and DEP it denotes the book depreciation expense.

Long-term Debt

The market value of long-term debt, MVLTD it , is obtained as

where BVLTD it is the book value of the long-term debt, i l is the rate of interest of the long-term debt reported in the Main Economic Indicators, and l it is the average cost of long-term debt, defined as l it =(IPLTD it /BVLTD it ), where IPLTD it is the interest payable on the long-term debt, which has been obtained by distributing the interest payable between the short- and long-term debt depending on the interest rates. That is,

where IP it is the interest payable; i s is the rate of interest of the short-term debt, also reported in the Main Economic Indicators; and BVSTD it is the book value of the short-term debt.

Market Share

This variable is computed as

where NS it denotes the net sales of firm i, and ∑i=1nNS it is the total net sales of its industry.

Size

Firm size is calculated as the natural logarithm of the replacement value of total assets.

Replacement value of total assets is calculated as

where RF it is the replacement value of tangible fixed assets, RI it is the replacement value of inventories, TA it is the book value of total assets, BF it is the book value of tangible fixed assets, and BI it is the book value of inventories. We obtain the last three terms from the firm's balance sheet, and we calculate the first two following the formulas described in Miguel and Pindado (2001).

Dividends

We compute the dividends as the dividends paid based on the current year's net income, scaled by the replacement value of total assets.

Tangible Fixed Assets

We compute the tangible fixed assets as the net book value of property plant and equipment, scaled by the replacement value of total assets.

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Hillier, D., Pindado, J., Queiroz, V. et al. The impact of country-level corporate governance on research and development. J Int Bus Stud 42, 76–98 (2011). https://doi.org/10.1057/jibs.2010.46

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