R&D Investments in the Presence of Knowledge Spillover and Debt Financing: Can Risk Shifting Cure Free Riding?

In an industry with knowledge spillover and debt financing, equilibrium investments in research and development (R&D) projects are subject to three economic forces. First, knowledge spillover among firms enables free dissemination of new technologies and produces investment synergies. Second, knowledge spillover also causes free riding: in equilibrium, firms underinvest in R&D expecting to benefit from investments by others. Third, debt financing creates incentive for risk shifting: equity holders overinvest in riskier R&D projects. We study how interactions among these forces affect a firm’s investment decisions and equilibrium industry outcomes using a three-stage game between two firms and the external debt market. We characterize subgame perfect, Pareto-dominant equilibria and show that for some parameter choices, free riding and risk shifting cancel each other in the decisions of individual firms, resulting in the first-best investments. Interestingly, for some cases, the equilibrium with first-best investments becomes possible only when risk shifting by one firm enables free riding by the other firm. We also show that debt can be used by firms as a commitment device in a multistage game. This value of debt is shared with investors, who can earn positive profits despite being perfectly competitive. This enriches the understanding of the financial pecking order theory by showing that even firms with unlimited internal capital may prefer external debt financing. This paper has been accepted for the Manufacturing & Service Operations Management Special Issue on Interface of Finance, Operations, and Risk Management.