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Executive and professional education

 

By Yuan Li, Research Associate, Cambridge Centre for Finance (CCFin) and Cambridge Endowment for Research in Finance

Many sketches and gear shaped objects on white paper representing a business strategy

Yuan Li

Dr Yuan Li

R&D investment has been playing an increasingly important role in the economy. However, accounting standard requires firms to immediately expense R&D as incurred. Therefore, R&D investment is not capitalized on the balance sheet. Could the unrecorded R&D capital affect our assessment of a firm’s risk? The answer is affirmative, according to the findings from a research project conducted by CERF research associate Yuan Li.

Finance theory suggests that a firm’s risk is negatively related to its flexibility to adjust capital investment. The more flexibility a firm has in this regard, the less its cash flows are affected by economic-wide conditions, and the lower its risk. Flexibility is hard to observe directly, but it can be inferred from the book-to-market ratio (BM). High-BM firms are generally burdened with more unproductive capital and hence less flexible to downsize in bad times. Thus, according to the theory, high-BM firms are riskier than low-BM firms, especially in bad times.

However, results from this project suggest that the above theory should not be followed blindly. This is because book-to-market ratio calculated from the balance sheet data increasingly misrepresents inflexibility and risk. This in turn is because book value is understated by the unrecorded R&D capital, which is even less flexible to adjust than physical capital. Results also suggest that considering book-to-market ratio and R&D capital together is a better way to evaluate a firm’s inflexibility and risk.