Allan C. Eberhart

A Reexamination of the Tradeoff between the Future Benefit and Riskiness of R&D Increases

Many previous studies document a positive relation between research and development (R&D) and equity value. Though R&D can increase equity value by increasing firm value, it can also increase equity value at the expense of bondholder wealth through an increase in firm risk because equity is analogous to a call option on the underlying firm value. Shi (2003) tests this hypothesis by examining the relation between a firms R&D intensity and its bond ratings and risk premiums at issuance. His results show that the net effect of R&D is negative for bondholders. We reexamine Shis findings and in so doing make three contributions to the literature. First, we find that Shis results are sensitive to the method of measuring R&D intensity. When we use what we argue is a better measure of R&D intensity, we find that the net effect of R&D is positive for bondholders. Second, when we use tests that Shi recognizes are even better than the ones that he uses, we find even stronger evidence of the positive effect of R&D on bondholders. Third, we examine cross-sectional differences in the effect of R&D on debtholders. Consistent with our main finding, we document a negative relation between R&D increases and default risk. The default risk reduction is also more pronounced for firms with higher initial default scores (where the debtholders have more to gain from an R&D increase) and for firms with more bank debt (where the debtholders have greater covenant protection from the possible detriments associated with R&D increases).

Comparable firms and the precision of equity valuations

Abstract I investigate the relationship between the amount of information provided by a firms comparables (i.e., firms in the same line of business as the firm being valued) and the precision of the firms equity valuation. When investors have more information, previous studies argue that investors can make a more precise estimate of a firms true equity value and this implies a lower (excess) stock return volatility around corporate events such as earnings announcements. I develop a simple model that shows a negative relationship between the amount of information provided by a firms comparables and the firms stock return volatility. Using alternative measures of information provided by comparables and different definitions of comparables, I consistently find a negative and significant relationship between these information measures and stock return volatility, ceteris paribus.

Equity Valuation Using Multiples

The valuation of equity using multiples of comparables is a highly popular technique that depends critically on two factors: the multiple that is used, and the comparables that are chosen. Recent research investigates which type of multiples produce the greatest valuation accuracy, but there is so far no extensive examination of the accuracy of alternative comparable firm classifications. The examination here finds that Dow Jones and Value Line provide significantly greater accuracy than more popular classifications such as the SIC codes.