CHAPTER
6Interdependencies among Corporate Financial Policies
I
n this chapter, we develop and empirically verify the hypothesis that firms
simultaneously determine their research and development, investment,
dividend, and new debt policies. In this chapter we introduce the reader to
the concept of effective debt, which holds that many firms use cash and/or
marketable securities as a store of financing (liquidity). Firms may issue
long-term bonds in excess of current need, reduce short-term indebtedness,
and put any surplus into cash and/or marketable securities. The effective
debt concept represents the net use of debt financing in a given accounting
period. The determinants of research and development, dividend, invest-
ment, and effective debt decisions of the U.S. firms in the WRDS database
are econometrically estimated during the 1952–2002 period for all firms
with assets in 2002 exceeding $200 million.
The purpose of this chapter is to estimate an econometric model to
analyze the interdependencies among the decisions concerning research
and development, investment, dividends, and effective debt financing.
We estimate the simultaneous equations modeling systems introduced in
Chapter 5. Financial decisions on dividends, capital expenditures, and
research and development activities are made while minimizing reliance
on debt funding to generate future profits. Management may issue long-
term bonds in excess of current needs and allocate the surplus debt into
cash and/or marketable securities if economies of scale exist in the debt
decision.
A firm has a pool of resources composed of net income, depreciation,
and new debt issues, and this pool is reduced by dividend payments, invest-
ment in capital projects, and expenditures for research and development ac-
tivities. We will develop and estimate our model having verified the
imperfect markets hypothesis concerning financial decisions. Financial deci-