IMPACT OF RESEARCH AND DEVELOPMENT EXPENDITURE ON PROFITABILITY OF FIRMS

ACCOUNTING AND FINANCE

Introduction
Innovation helps in the generation of quality goods and services, which are highly competitive. A firm embracing innovation will have better allocation of resources and will be able to multiply its profits at a rate higher than that of firms not engaged in the process of research and development. Besides medical companies, manufacturing companies need a heavy investment in the research and development process considering their competitive business environment. The primary objective of this paper is to analyze the impact of the research and development function on the overall profitability of an organization. The paper will take into account the production function theory and the creative destructive model as proposed by Schumpeter. With the help of these theories and results previously achieved by various scholars, a testable hypothesis would be formulated. To establish a significant relationship, various statistical tests such as regression analysis, and correlation would be performed. To perform a statistical analysis, an empirical model would be constructed wherein the dependent and the independent variables would be tested against the control variables. The results from the test will be discussed to form the basis of further research.

Literature Review
Expenditures in research and development are usually dejecting if their respective ratios against sales result into an influential shock to cause a decrease. Such a situation occasionally appears as a warning to an organization. In this case, the effectiveness of the accounting measures like book values and earnings usually rely heavily on the ability of these factors to serve as an indicator or warning values that will enhance decision-making in a firm. Given that the uncertainty level associated with research and development productivity appears greatest especially at the beginning of a research project, it is usually important to choose an optimizing research and development structure that would enhance conducting the investigation into the desired level.
Main Research Question
What is the effect of research and development expenditure on the profitability of firms?
Hypotheses
1. H0= Research and development expenditures of a firm increases a firm’s profitability level.
2. H1 = Research and development expenditures of a firm do not increase its profitability level.
Related Studies
Numerous studies have been conducted in the area of accounting and finance for purposes of predicting the profitability of firms by considering online data that is available in online databases. This activity was performed to forecast and find out the factors for research and growth of expenditure in a firm, and also the factors that influence it. Liquid assets invested in short-term plays an important role in a company’s decision to develop new products. Firms consist of market shares and they are building the barrier by the Research & Development activities to develop new products and technologies (Breitzman, et al, 2002). Gao (2013) had proposed some hypotheses that state “Private Firms hold huge cash reserves than analogous public firms”. His approach on cash holdings and profitability of organizations involves the auditing activities that are used for forecasting a firm’s growth. A correlation Matrix is used to identify the relationship that exists among the variables in the system. The hypothesis testing is used when a correlation is not sufficiently clear.
Kavadias (2009) identified a key metric for the assessment of research activity in firm levels the Research & Development intensity, which is defined as the ratio of a company’s R&D investment related to their revenue. The level of Research and Development activity contributes significantly to the growth of U.S manufacturing company (Grilches, 1979). A firm in US spends more on research and development, which is relative to its sales income (A Congressional Budget Office Study, 2006). Organizations that encourage more R&D activities tend to have more sales income when compared with those firms that perform less R & D activities.
According to Morbey and Reithner (1990), there is a positive relationship between research and development expenditure and the sales or revenue earned by an organization. A study conducted on 51 companies in the chemical segment in the year 1988 indicated that organizations with above average expenditure on research and development activities had above average sales and vice-versa.
According to Branch (1974), Research and Development expenditure and the profitability of a firm have mutual influence relationship, where there is a tendency for R&D to persuade the future profitability. In addition, according to the views of Archarungroj & Yasuo (1999) there is an optimistic relationship between Research & Development expenses and their profitability.
According to the F.M. Scherer (2001), the principles, profitability and investment in technology can be associated with 3 special customs: First, flourishing of latest technology can be very much useful to a firm’s earnings. Secondly, the profit acquired by a firm serves as a foundation of resources to support the R&D investments. Third, managers’ prospect of potential profit opportunities can be used to apply a demand-full influence on the technology implementation and development.
Notably, firms with a value greater than the projected profits resulting from effective Research & Development efforts of the individual firm present it with the persistence (Eklund, 2007). The income that they receive will be used to determine the firm’s strategy to put in the development of technology related research and development.
Further discussion is warranted by the characteristics and nature of the function of research and development activities undertaken by a firm as such functions are not risky and costly and generally time consuming. Another important aspect is that the profitability of an organization cannot be linked with such activities. Basic and applied researchers are the two basic forms of this function. The process which allows an individual to gain knowledge is known as basic research and development whereas the process which allows an organization to develop new products, methods of production, new processes etc. which leads to an increase in the revenue of the organization is referred to as applied research. The function of research and development is not always aimed at the increment of revenue but the same can also be directed towards the reduction of cost of an organization thereby increasing the profits of the particular firm. In a survey where 600 organizations participated in the year 1977, it was revealed that out of 600 organizations, 354 organizations wanted or engaged in the function of research and development with the aim of bringing about an improvement in the existing product. 168 organizations out of the 600 organizations interviewed stated that they undertook research and development activities with the purpose of developing new products and 78 organizations stated that they undertake such activities to bring about an improvement in the manufacturing process (Aggarwal & Samwick, 1999). As has been mentioned previously the process of research and development enables the concerned firm to introduce new products, services, new processes etc. with the aim of improving the revenue or bringing about a reduction in the cost structure. Research and development plays an important role in the development and the growth of an organization. Innovations and ideas are categorized as public and free goods. Previously, the function of research and development in the USA was driven by the government. However, this trend changed in the 1980’s with the entry of the private firms. These firms were the extension of their owners as per the classical model. Large organizations require huge amounts of funds for their operations, which necessitate the influence of multiple owners. However, considering the varied backgrounds of the owners, they are not able to lend their thoughts or help out with the day-to-day operations and hence this responsibility is entrusted with the managers of the organization. The classical theory in this regards, points out that though the managers run the firms, it is the shareholders who control their actions. An efficient organization paradigm can be the separation of ownership, which if executed successfully can lead to the success of the organization. Conducting the operations of the organization through an agency relationship is costly and the managers and the CEO of a concerned firm are the agents of the shareholders of the organization and their responsibility is to run the operations of the organization in a way that suits the interests of the shareholders. They thus, incur a lot of cost, which forms the primary focus of the agency costs (Laffont & Martimort, 2002). In 1994, Chernesky developed a model that established a relationship between the research and development activities of an organization and its profitability. The main thought flowing through this theory is that the agents of the organizations are the maximizers of welfare and their acts are often directed towards self-interest. The information asymmetries arise as a consequence of lack of information and differences in interests. The shareholders are not accustomed to the way the managers deal with certain situations and the managers are not accustomed to the way the shareholders would want them to handle the same. This consequentially leads to the creation of a moral hazard. The managers tend to promote their own interests and not the interests of the shareholders, especially when their actions are not monitored by the organization to establish their conformity to the firms’ values, standards and principles. An increase in the self-leisure activities, rising compensation, negative stance on takeovers or mergers which would have presented the organization with new opportunities as their powers would be divested are examples of such behaviors. With the increased monitoring of the activities of the managers, an organization can take care of such problems… For non-corporate decision making the agency cost model has proven to be useful, but the same is not used in corporate decision making (Cherensky, 1994). Considering the risky nature of the research and development expenses and the absence of a direct nexus between the same and the revenue or the profitability of the organization this model is employed. This model lends a more meaningful insight into the complex relationship. For the purpose of simplicity of calculation, the model expresses the R&D expenses as a percentage of organizational revenue. The importance of breaking down the interests of the shareholders is illustrated by the table below:

Source: (Cherensky, 1994)
The table above indicates the fact that interests of a few shareholders are in line with the interests of the managers. The agency cost model is complicated as the interests of various shareholders vary in terms of the research and development expenses. Indexation can be done by undiversified and diversified shareholders due the lost cost of investment in indexed funds. The interests of the indexed shareholders and the interests of the society are in line for the same reason. From table 1; it is evident that none of the managers or the shareholders favors basic research. Both of these groups are in the favor of applied research, as that would allow the organization to increase revenue or reduce cost. The table also points out that most of the shareholders of the organization are in favor of intensive research and they disregard the associated risks. On the contrary, the managers of the organization are not in favor of risky projects and favor projects that are less risky in nature. This theory points out that agency costs are a better explanation for corporate underinvestment than are myopic markets (Cherensky, 1994). A research conducted by Pakes documented a positive relation between the market prices of the stock and the changes of unexpected nature in the R&D. This study indicated that the value of the firm changed to the tune of $1870 with a $100 change in the research and development expenses of the firm. The fact that institutional investors favor increased spending in research and development activities was documented by this research. A study conducted by the SEC in 1984 pointed to the fact that “direct and statistically significant relationship between institutional ownership and R&D expenditures.”
As there is no tool available to inspect the behavior of management towards research and development expenses, this aspect would be reviewed in an indirect manner by focusing more on the size of the firm and it’s spending on R&D (Cherensky, 1994). According to the traditional theory, competitive markets are best suited for organizations since with increased R&D spending they seek to obtain a monopoly position. The managers of the firms with market dominance position are less concerned about the risks associated with spending in research and development. The theory also points to the importance of the quality of R&D spending rather than the amount. The agency model predicts increased spending on R&D up to a specific size of the firm after which the same is bound to decrease. According to Scherer (2001), the spending on R&D increased less than proportionately with an increase in the size of the firm. The study indicated that the R&D spending was more than proportionate in smaller firms.

Source: (Cherensky, 1994)
From the figure, it is clear that the R&D activities are not consistent. The study examined the behavior of 890 firms and categorized them in 9 sections.

Source: (Cherensky, 1994)
This figure reveals some interesting facts about the R&D spending and the size of the firms. This points to the fact that rather than being concentrated towards the mean, the firms displayed a radical R&D spending behavior (either extremely high or low). Hence, it can be said that the R&D activities increase with an increase in the size of the firm and decrease with a reduction in the size of the firm. It was evidenced in the 1980’s that intense acquisition behaviors of the organization were a hindrance to the R&D spending of the organizations, the main reason for the same being that due to the increase in the proportion of debts as a consequence of the acquisitions, the risky activities of the managers are not encouraged. This is specifically true in the case of research and development expenses. A study conducted by Hall states the fact that the R&D spending is not impacted by the acquisition or merger activities of an organization whereas, NSF study stated the opposite (Cherensky, 1994). A research by the chief economist of SEC tried to establish a relationship between the R&D spending of a firm and the chances of it being involved in acquisition or merger activities. The data obtained through the study strongly suggested that R&D activities of the firm have no impact on the acquisition or mergers.
Incremental Difference
The research question is different from the above-specified literature as:
• First, if the firm is spending in technology-based research then the research supports increasing the purchase and it also supports improving the profits of the firm.
• Second, firms that are spending on technology are possibly funding their projects through liquid assets, which would be considered establishing profits.
Proposed Methods
1. Specified firms can utilize their previous datasets located in Wharton Research Data Services –compustat, by using the powerful web query methods and various tools like python, Relenium and R and Eeeviews.
2. For the complete sample, download required firm’s account details from the respective COMPUSTAT website and perform the necessary activities (if required). This process can also be automated using the web-scraping tool Relenium in R. The files can be stored in cloud storage, Microsoft One Drive using the Internet.
3. A Time series analysis can be used to forecast the profits of the firm. The COMPUSTAT website can be used to gather the data and we use later the R programming language to apply those time series based algorithms from statistics to forecast the profitability of the firm.
4. R software can be used to apply various forecasting algorithms on the firm data and then by using the previous data we can use those prediction algorithms to predict the future profit of the firm, as there are many parameters to be considered. Various cash flow and organization balance sheets can be used in the analysis of the liquid assets, audit of their value and then calculation of the correlation. If the relationship is positive then it is easier to predict the profit of the firm.
Various statistical tests would be performed on 3,000 US public companies from various segments such as manufacturing. Considering the time constraints, it is not possible to cover all the US listed companies or with operating time spans which are longer than 10 years starting from 2004. Thus, the tests would be performed on the data of 10 years. However, for the purpose of this hypothesis testing, organizations with a history of acquisition or similar activities would be avoided as such activities can bring about an alteration in the scale and magnitude of the business in ways not linked to the organization’s research and development activities.
Data
For the purpose of this research, the data would be accumulated from Compustat and other similar databases. To compute various factors, the data procured would be adjusted due to differences among companies. A total of 5,008 companies are listed in the United States, out of which, firms that do not use R&D are approximately 1500, resulting to 3,508 firms that will be used for the purpose of this research. However, around 508 listed companies were accounted for among the missing variables. Hence, giving a net value of 3,000 whose data was collected for analysis. Varied techniques such as regression, ordinary least square and descriptive statistics would be employed for establishing the relationship between the research and development activities of an organization and its profitability. The purpose of conducting this research on manufacturing industries is that these organizations are focused on research and development activities. Conducting the research on such organizations that are focused on R&D activities will enable to derive the best results Manufacturing industries have to innovate with time considering the volatile business environment they operate in. For the purpose of analyzing the profitability of the organizations, the return as against the respective stock prices would be considered. The motive for using the firm’s stock price is that the same is a representative of the firm’s present value of the future net earnings.
Regression Model
The variables that would be employed for the purpose of analysis in this paper have been described or illustrated below:
RDC= RD + 0.8*RD (previous year) +0.6RD (two years ago) +0.4RD (three years ago) + 0.2RD (four years ago)
The equation above will enable the researcher to estimate the R&D intensity. It is assumed that that every dollar spent would decline linearly by approximately 20% each year. The research and development expenses of the previous years will enable us to arrive at the R&D capital. To explore further the impact of commonly used valuation measures, we compare earnings under the current practice of immediately expensing R&D spending with “adjusted earnings” calculated using an estimate of R&D expense. Similarly, a comparison to the book value of common equity with a measure of book value (“adjusted book value”) is made.
An investment strategy based on R&D intensity is assumed by this paper in order to account for the benefits expected in the future that may arise from R&D spending. The research and development expenses are measured as a percentage of sales to account for the research and development intensity. The second indicator being the R&D expenses in relation to the market value of the equity of the organization.
It is quite possible that the risk differentials might be displayed by the R&D intensive stocks. It has been proven in the past that stocks ranking high on R&D to market equity have earned lower returns. Hence to control such factors the below-mentioned regression has been assumed:

Hence, the monthly returns of the portfolio in excess of the return on treasury bills are indicated by Rpt-Rft. SMB and HML indicate the returns on the FAMA and FRENCH factor mining portfolios for size and market to book value respectively. WML and UMD represent the long term and short term returns respectively.
Hence, the regression equation that would be followed has been stated below:

The stock returns volatility or the standard deviation equals the stock market capitalization of the firm, the age of the firm, and its research and development percentage to sales. The dummy variable of INDijt has been included to account for the conditions of the business in the technology sector. Then we average the estimated coefficients from the cross-sectional regressions overall portfolio-formation years and use the time-series standard deviation of the coefficients to calculate t-statistics.

Results
R&D of each firm is evaluated from its past history of expenditures. The available literature shows no consensus on the estimates on expenditures across useful life and the rate of amortization. Based on literature reviews, the adopted tactable equation is as presented in the following:

Assumptions from the equation:
1. Productivity of each dollar spend reduces directly by 20% annually.
2. Capital ammortization rate is almost 15% close to the one used in an influential compiled databae.
Stock Returns and R&D
In order to evaluate the behavior of the stock market and whether it can be influenced by the anticipated gains from the expenditure in R&D, the paper assesses its intensity. First, the R&D expenditure is measured in relation to the sales. Sales is a largely used variable for indicating how the firm spends in R&D. Intensity will also be measured by the R&D expenditure ratio to the equity value of the market. Particularly, it is possible to interpret this intensity measure based on other conventional indicators such as book-to-price or the earnings ratio, especially when it is scaled to the market value of equity. If R&D is sorted in this way in relation to the market, stocks having large R&D expenditure are highlighted in addition to the market values that are relatively depressed. All the common stocks that are listed on the domestic market, that is, the NASDAQ, American Stock Exchange and the New York are taken into consideration. The stock portfolios are established towards the end of April of every year based on the most current accounting data. The eligible stocks are ranked based on the R&D intensity measure and then assigned to any of the five portfolios. Since the main focus here is evaluating the results across a long horizon, equally weighted annual buy-and-hold gains are calculated across three years before the formation of the portfolio. The following tables observe a variety of these issues.
Table 1: The Impact of R&D Expenditures on Book value and Earnings for the Selected Industries
For the year 2010, the net earnings of the R&D expenditures and R&D expenditure net earnings are calculated every domestic firm listed on the AMEX, NASDAQ and NYSE with information acquired on COMPUSTAT files and those engaged in the R&D expenditures. The classification of firms based on industry is determined by the SIC codes. Total adjusted and unadjusted earnings for each of the industry are presented in terms of percentages of the equity value of the industry market (Panel 1). Additionally, the book value of equity, including the R&D capital are calculated and presented in the same way in (Panel 2). The chosen industry contains at least 50 firms each and ranked by 2004-2014 R&D expenditures relative to industry sales.
Panel 1: Earnings
Industry Earnings as the % of Market Value Adjusted Earnings as the % of Market Value
Drugs and pharmaceuticals 3.68 4.77
Computer Programming & Services 1.94 4.27
Measuring Instruments 4.1 4.51
Communications 2.5 2.99
Electrical Equipment 5.43 6.42
Computers and office equipment 4.45 5.71
Transportation Equipment 5.98 7.3
Panel 2: Earnings
Industry Earnings as the % of Market Value Adjusted Earnings as the % of Market Value
Drugs and pharmaceuticals 16.1 24.5
Computer Programming & Services 14.5 22.5
Measuring Instruments 28.3 38.7
Communications 17.8 24.22
Electrical Equipment 30.75 38.62
Computers and office equipment 33.6 52.5
Transportation Equipment 45.2 66.1
Table 2: Returns and the Characteristics of Portfolio Classified by Research and Development Expenditure with reference to Sales
All stocks are ranked based on R&D expenditures with reference to sales at the end of April of each year starting from 2004 to 2014. Stocks that do not have R&D expenditures are allocated to a different portfolio. The content of the sample is the AMEX, NASDAQ and the NYSE domestic basic issues covering COMPUSTAT and CRSP files. Under Panel 1, the annual average of buy-and-hold profits for each portfolio is presented over the 5-year before the formation of the portfolio, from year 1 to 3 after the formation of the portfolio, averaged to 3 years after the formation. Under Panel 2, a report of the average of each portfolio return in the excess of equally weighted returns of the portfolio control is exhibited. This is arranged in accordance with the size of the firm and the adjusted equity book value across the 1st to 3rd after the formation years. Panel 3 shows the excess returns that are based the control portfolios matched by the size of the firm and the adjusted equity value of the book in relation to the market equity. Panel 4 shows the portfolio characteristics, which includes the R&D expenditure ratios, stock components average, sales and earnings in relation to the market value of the equity. In addition, the panel also includes the annual dividends divided by the equity market value, equity returns and its logarithmic values. Finally, Panel 5 gives a summary of the yearly growth rate for each portfolio earnings over a five –year period after the portfolio has been formed.
1 (low) 2 3 4 5 (high) Non-R&D
Panel 1: Returns and After the Formation of Portfolio
Annual Returns (Average) 0.189 0.191 0.204 0.207 0.225 0.203
5-year prior to portfolio formation
Year 1 after formation 0.192 0.207 0.211 0.2223 0.232 0.241
Year 2 after formation 0.174 0.194 0.201 0.2167 0.230 0.244
Year 3 after formation 0.181 0.188 0.201 0.21 0.220 0.230
Annual Returns (Average) over year 3 after the formation of portfolio 0.182 0.197 0.205 0.2177 0.229 0.241
Panel 2: Excess Returns after the Formation of Portfolio
Year 1 after formation -0.006 0.207 0.211 0.217 0.182 0.199
Year 2 after formation -0.013 0.009 0.021 0.025 0.033 0.004
Year 3 after formation -0.007 0.004 0.019 0.024 0.039 0.006
Average annual returns(excess) over year 3 after the formation of portfolio -0.008 0.009 0.019 0.027 0.027 0.025
Panel 3: Excess Returns based on the Adjusted Book Value
Year 1 after formation of portfolio -0.006 0.009 0.002 0.027 -0.003 -0.002
Year 2 after formation of portfolio -0.013 0.006 0.017 0.019 0.025 0.004
Year 3 after formation of portfolio -0.008 0.004 0.017 0.017 0.031 0.006
Average annual returns(excess) over year 3 after the formation of portfolio -0.009 0.007 0.018 0.021 0.017 0.003
Panel 4: Portfolio Characteristics
Number of firms (average) 237.1 255.3 234.9 235.8 236.1 1852.6
R&D against the market 0.0137 0.032 0.057 0.081 0.109 0.00000
R&D against sales 0.004 0.014 0.029 0.057 0.226 0.00000
Adjusted book-to-market value 0.985 0.975 0.976 0.939 0.816 0.90050
Book to market value 0.899 0.851 0.8 0.701 0.818 0.90040
Sales-to-market 3.167 2.561 1.955 1.349 2.678 2.861
Dividend yield 0.08 0.067 0.054 0.041 0.028 0.015
Earnings-to-price 0.032 0.026 0.02 0.014 0.008 0.002
Return-on-equity 0.145 0.109 0.073 0.037 0.001 0.107
Log size 4.561 4.651 4.741 4.831 4.921 5.011
Panel 5: Annual Growth Rates (Average) after formation of Portfolio
Yearly earnings growth across five years after the formation of portfolio 0.073 0.108 0.108 0.077 0.142 0.102
Table 3: Returns and the Characteristics of Portfolio Classified by Research and Development Expenditure with reference to Market Value
All stocks are ranked based on R&D expenditures with reference to sales at the end of April of each year starting from 2004 to 2014. Stocks that do not have R&D expenditures are allocated to a different portfolio. The content of the sample is the AMEX, NASDAQ and the NYSE domestic basic issues covering COMPUSTAT and CRSP files. Under Panel 1, the annual average of buy-and-hold profits for each portfolio is presented over the 5-year before the formation of the portfolio, from year 1 to 3 after the formation of the portfolio, afterwards, averaged to 3 years after the formation.
1 (low) 2 3 4 5 (high) Non-R&D
Panel 1: Returns and After the Formation of Portfolio
Annual Returns (Average) 0.289 0.291 0.213 0.217 0.225 0.203
5-year prior to portfolio formation
Year 1 after formation 0.192 0.207 0.211 0.2223 0.232 0.241
Year 2 after formation 0.174 0.194 0.201 0.2167 0.230 0.244
Year 3 after formation 0.156 0.181 0.191 0.211 0.229 0.246
Annual Returns (Average) over year 3 after the formation of portfolio 0.138 0.168 0.181 0.2053 0.227 0.248

Panel 2: Excess Returns after the Formation of Portfolio
Year 1 after formation -0.006 0.207 0.211 0.217 0.182 0.199
Year 2 after formation -0.013 0.009 0.021 0.025 0.033 0.004
Year 3 after formation -0.02 0.19 0.172 0.189 0.761 0.130
Average annual returns(excess) over year 3 after the formation of portfolio -0.027 0.89 0.56 0.452 0.156 0.215

Panel 3: Excess Returns based on the Adjusted Book Value
Year 1 after formation of portfolio -0.006 0.009 0.002 0.027 -0.003 -0.002
Year 2 after formation of portfolio -0.013 0.006 0.017 0.019 0.025 0.004
Year 3 after formation of portfolio -0.008 0.004 0.017 0.017 0.031 0.006
Average annual returns(excess) over year 3 after the formation of portfolio -0.009 0.007 0.018 0.021 0.017 0.003

Panel 4: Portfolio Characteristics
Number of firms (average) 0.215 0.261 0.307 0.353 0.399 0.445
R&D against the market 0.08 0.067 0.054 0.041 0.028 0.015
R&D against sales 0.032 0.026 0.02 0.014 0.008 0.002
Adjusted book-to-market value 0.145 0.109 0.073 0.037 0.001 0.107
Book to market value 0.1507 0.109 0.068 0.0267 0.561 0.1333333
Sales-to-market 0.1832 0.13 0.078 0.0247 0.61 0.1793333
Dividend yield 0.2157 0.151 0.087 0.0227 0.8865 0.2253333
Earnings-to-price 0.2348 0.162 0.089 0.0165 1.1231 0.2713333
Return-on-equity 0.2592 0.177 0.094 0.012 1.3597 0.3173333
Log size 4.561 4.651 4.741 4.831 4.921 5.011
Panel 5: Annual Growth Rates (Average) after formation of Portfolio
Yearly earnings growth across five years after the formation of portfolio 0.073 0.108 0.108 0.077 0.142 0.102
Discussion
Results of Portfolio Based on the R&D in relation to Sales
Table 2 gives the results for the portfolio that are sorted based on the R&D intensity in relation to the sales. In most cases, however, it is always thought that companies undertaking R&D, for instance, the technology companies exhibits a strong performance in stock price. However, the average raw returns as exhibited in Panel 1 for firms that conduct R&D is not different from firms that are not conducting R&D. Taking average across the five stock groups performing R&D, for instance, the mean of yearly returns in three years prior to the formation of stocks yield 19.6% for the firms undertaking R&D and 19.4% for those not undertaking R&D. The relationship between the average of stock returns in the presence and absence of R&D confirms that firms having increased research spending are likely to benefit in the market compared to those not working on increased expenditure in R&D.
Looking across Panel 1 on the firms involved in the research activity, little relationship between the R&D in relation to the sales and future profitability. The profitability levels are almost similar to the panel in the five portfolios. Within the three years prior to portfolio formation, for instance, the highly intensive portfolio yields on average, 19.7% each year for the entire group of R&D firms. Firms that are ranked high by their R&D with reference to sales often appear to have attractive stocks, with a low ratio of sales-to-price, book-to-market equity, earnings-to-price and dividends.
Results on R&D in relation to the Market Value
Under table 3, the results for the portfolios that are sorted by the R&D expenditures in relation to the equity market value. As shown in Panel 4, there is a correlation in the two measures for R&D intensity with reference to sales since it is difficult for firms in the pharmaceutical industry to exhibit a high rank under the R&D in relation to the market value. Stocks that are located in the top quartile reports a good performance in the period prior to portfolio formation. On average, firms with high R&D expenditures earn approximately 24.6% in their first and subsequent period compared to those without R&D whose average earnings are approximately 16.53%. Across the three years after portfolio formation, the same trend is still being observed across the firms.
Table 4: Summary R&D Statistics for 3000 Firms
2004-2007 2007-2009 2009-2012 2012-2014
R&D Expenditures
Mean 6214 7246 8889 9039
Median 2044 2129 2080 1879
Standard Deviation 12147 13857 17780 19897
R&D Intensity (%)
Mean 1.9 2.3 3.1 1.7
Median 0.7 0.71 0.81 0.81
Standard Deviation 3.1 5.2 11.2 2.7
To find out the R&D expenditure variations, a calculation of percentage changes in the R&D expenditures for the firms in four possible year by year calculations is made. The figure below plots the highest and lowest percentage changes for the firms in the sample and joins the highest and lowest points using a vertical line. To examine the figure, it is worth noting that the long vertical line shows that the R&D expenditures have substantially changed. In the figure, a horizontal line is marked at 0%. In case the vertical line extends below this line, it implies that the annual level of R&D has decreased at some points. At the same time, the figure shows that many firms exhibit high volatility in their R&D expenditures while others reports a reduction in the expenditure. Firms are along the horizontal line. In this way, it is possible to see that there is no obvious variation in the volatility based on expenditure size for the firm.
Figure 1: Volatility of the R&D Expenditure

Lastly, the size of the firm in relation to expenditure in R&D is also worth examining. The reason is that, R&D intensity increases with increase in the size of the firm which has a significant influence of profitability levels. Figure 2 below summarises the average R&D intensity against average sales of the firms from the sample. From the figure, it can be observed that small firms that have high intensity, approximately 10% dominate. This implies that there is a negative relationship existing between the R&D intensity and the total size. Whereas, the bivariate plot analysis can possible alter the relationship.
Figure 2: R&D intensity against the Size of the Firm

Summary and Conclusion
R&D is an intangible asset that many firms value a lot in the current economic times. However, such assets are rarely reported in many firms’ financial statements. Considering that the expenditure on R&D is treated as among the current expenses, it can heavily affect the company’s financial statements. The paper has addressed the effect of an increase in expenditures on R&D has on the level of profitability of a firm. Across the analysis, having high R&D may largely contribute to increased costs to the firm rather than facilitating achievement of high profitability for the firm. In this case, investment in R&D requires that the firm ensures it has an adjusted level of valuation across major components that determine profitability across the firm such as sales, price-to-earnings ratio or to book value for most of its assets if it hopes to benefits from R&D. The results, however, do not exhibit a direct relationship between expenditure on R&D and the future benefits. As the study indicates across the assessment on stocks, an average return of 24.6% annually is achieved when firms increase expenditures on R&D. On the other hand, firms that do not spend on R&D are reported to earn a profit level of approximately 16.53% or below. Further, there is no strong relationship between the intensity of R&D determined based on sales and the future profitability. However, a strong relationship between the expenditure on R&D with relation to market value shows that increased R&D have a positive role in the future profitability of a firm. In conclusion, the profitability level of a firm is not entirely affected by the level of expenditure made on R&D. However, R&D has a significant influence on the direction the firm takes towards the future profitability.

References
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Heitor Almeida. Et al. 2014. Corporate Liquidity Management: A Conceptual Framework and Survey. Annual Review of Financial Economics. 6 135-162.
Huasheng Gao, Jarrad Harford, Kai Li. (2013). Determinants of corporate cash policy: Insights from private firms. Journal of Financial Economics (Elsevier). 109 623-639.
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