Strategic debt and patent races

Most traditional studies of R&D do not consider that the use of leverage to finance R&D may affect total R&D expenditures in a patent race. We show that debt acts as a commitment to a smaller amount of total R&D spending (debt+equity) than would occur if firms were entirely equity financed. A commitment to lower R&D expenditure can be strategically beneficial; under a flow-cost model, debt induces lower R&D expenditure from its rival and thus increases its expected profit. Firms in this case are partially debt-financed in equilibrium. In a fixed cost model, debt has no strategic value in a symmetric equilibrium. In this case debt induces higher R&D expenditure from its rival and thus decreases its expected profit. Firms in this case use no strategic debt, and may in fact use "negative" strategic debt; that is, in a more general model where debt has other uses, the total debt level is reduced when the strategic effect is included. Our empirical study gives support to the fixed, tip-front R&D result that higher debt levels are associated with lower overall R&D expenditures. (C) 2004 Elsevier B.V. All rights reserved.