Innovation Output and the Cost of Funds

Do firms with higher levels of innovation output, measured by patent counts and citations, enjoy lower costs of funds? The process to develop and apply for patents involves valuable resources. Thus, applying for a patent is a credible signal that the underlying invention is valuable. This value is validated to some degree when the patent is granted. In addition, patents contain detailed information about the firm's inventions and provide collateral value as they can be sold and licensed. The number of citations a firm receives act as a proxy for high-quality inventions, active networking, and pioneering. These attributes are expected to attract investors and reduce the cost of funds. Univariate and cross-sectional regression analyses of a sample consisting of 404,595 firm-years, involving firms from twenty-eight countries spanning from 1976 to 2012, demonstrate a significant negative association between innovation output and the cost of funds. The evidence suggests that the marginal benefit of innovation diminishes as innovation output increases. The results are robust to different measures of the cost of equity and the cost of debt. The negative association between the cost of equity and innovation output is economically larger for younger and smaller firms. The long-term level of innovation seems to be more important to shareholders than short-term changes of innovation. In addition, shareholders demonstrate an ability to discern between low and high-quality innovations, as they require lower rates of returns when initial patents exhibit a high quality. Shareholders place more value on innovation output when firms operate in countries with legal systems that are more effective in controlling self-dealing practices, in countries that have higher economic freedom, and in countries that have more developed financial markets. The correlation between the cost of debt and innovation output is predominantly derived by larger, more mature, and more leveraged firms. Innovation output and the cost of debt are not correlated for low levels of innovation; however, medium and high levels of innovation output relative to peer firms are associated with lower costs of bonds. The findings suggest that the effect of innovation on the cost of debt is stronger in countries with more developed financial markets and in countries characterized by higher levels of economic freedom. Practices that control for self-dealing do not affect the association between innovation output and the cost of debt