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24 September 2020 CFA Institute Journal Review

Economic Policy Uncertainty, Cost of Capital, and Corporate Innovation (Summary)

  1. Butt Man-Kit, CFA

CFA Institute Journal Review summarizes "Economic Policy Uncertainty, Cost of Capital, and Corporate Innovation," by Zhaoxia Xu, published in the Journal of Banking & Finance, February 2020.

Government economic policy uncertainty increases firms’ cost of capital, which in turn hampers corporate innovation. The effect is more pronounced when firms are under more stringent regulations, when the cost to reverse investments is higher, when there are more financial constraints, and when there is more competition. During times of uncertainty, firms issue capital less frequently and for smaller amounts.

What Is the Investment Issue?

An increase in government economic policy uncertainty (GEPU) is expected to hurt the economy, but the mechanism behind this dynamic is not well known. The author observes a negative relationship between GEPU and corporate innovation. The study shows that the negative outcome can be ascribed to a higher cost of capital and lower investment, both resulting from undiversifiable policy risk associated with GEPU.

How Did the Author Conduct This Research?

The author uses data from the United States for the period 1985 to 2007 to examine the relationship among GEPU, cost of capital, and innovation.

To measure GEPU, the author first constructs an economic policy uncertainty (EPU) index that counts the number of articles containing terms related to economic uncertainty in 10 of the largest newspapers. The types of uncertainty include tax expirations, inflation forecast disagreements, and government purchase agreements. Some may argue that the EPU index correlates to certain macroeconomic variables, such as industrial production and recession. To capture uncertainty attributable to economic policies, the EPU index is regressed on these macroeconomic variables, and the residual of the model is used to construct a GEPU measure that excludes the impacts of these factors.

The measures for cost of equity and debt are more straightforward. The cost of equity is estimated by a residual income valuation model that uses data from I/B/E/S and CRSP, and the cost of debt is measured as the actual yield on the debt.

To measure innovation activities, the author extracts patent and citation data from the United States Patent and Trademark Office. After the innovation data are matched with firm-level financial data, the final sample consists of 12,408 firms and 101,502 firm-year observations from 1985 to 2007.

The author then regresses the innovation variables and cost of capital variables on GEPU in separate models and finds that GEPU significantly explains both. The author further builds a series of regression models to test whether these effects would be moderated by factors of exposure to government policies, irreversibility of investment, financial constraints and market competition, and external financial dependence.

The author uses an instrumental variable approach to address endogeneity concerns between GEPU and innovation. Models estimated by alternative measures of variables also produce consistent conclusions.

What Are the Findings and Implications for Investors and Investment Professionals?

The findings help investors to identify firms that would be seriously affected during times of economic policy uncertainty. The results show that GEPU can be a useful prediction variable (although not to be confused with other macroeconomic forces).

In particular, a high level of EPU will cause firms to spend less on R&D, leading to fewer and fewer patents. During times of high uncertainty, firms experience a higher cost of equity, a higher cost of debt, and a higher weighted average cost of capital (WACC). The frequency and the size of capital issues both decline in times of high uncertainty.

The uncertainties in policy impose greater pressure on firms that are regulated more stringently. These firms recorded even higher WACC than those more lightly regulated. Because of the higher cost of capital, it is not surprising to observe that these firms also have lower R&D investment and patents.

Similarly, industries that have higher costs to reverse investments may lower their R&D spending under uncertainty. These industries include those that are highly cyclical, with high sunk costs (such as rent, depreciation, and disposal of assets), as well as those with low redeployability of assets. The findings show these firms have lower R&D investment.

Moreover, the negative effect of GEPU on innovation is also stronger when firms have constraints in finance. For those firms discussed, potential delay in investment as a result of financial constraints in their management discussion and analysis (MD&A) sections led them to exhibit more hesitation in R&D investment during times of high uncertainty. The same logic applies to competitive industries that earn little economic rent, with these firms recording lower R&D investment and lower innovation during times of higher uncertainty.

Because innovation is a key driver of firm value and competitiveness in the long run, the impact of policy uncertainty, and its heterogenic effects on different industries, should not be neglected in making valuations.

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