Journal of Business Finance & Accounting, 34(1) & (2), 222246, January/March 2007, 0306-686X doi: 10.1111/j.1468-5957.2006.00651.

The Association of R&D and Capital Expenditures with Subsequent Earnings Variability
Eli Amir, Yanling Guan and Gilad Livne

Abstract: We estimate the association of investments in R&D and in physical assets (CAPEX) with subsequent earnings variability. We estimate these relations in different time periods and across industries. We find that R&D contributes to subsequent earnings variability more than CAPEX only in relative R&D-intensive industries industries in which R&D is relatively more intensive than physical capital. In physical assets-intensive industries, we do not find similar relations. The findings suggest that with respect to subsequent earnings variability, fundamental differences between investment information about R&D and CAPEX exist. However, they are mainly noticeable in firms that operate in relatively R&D-intensive industries. The evidence also suggests there was a shift in the relations between R&D and CAPEX over time. Our findings contribute to the debate on accounting for R&D expenditures. Keywords: industry analysis, research and development (R&D), capital expenditures (CAPEX), earnings variability, SFAS 2

1. INTRODUCTION

Notwithstanding the increasing importance of corporate R&D programs and investments in intangible assets, for many companies capital expenditures on physical assets are as crucial for the generation of future growth and increase in value. Thus, information on both R&D and capital investments is relevant for assessing a companys future profitability and risk profile. Generally accepted accounting principles in the United States (US GAAP) require that all R&D expenditures be expensed when incurred, while capital expenditures (CAPEX) must be capitalized and depreciated over their economic useful lives or
* The first and second authors are from the London Business School. The third author is from the Cass Business School, City University of London. They wish to thank Peter Pope (Editor), an anonymous referee, Dan Weiss, and seminar participants at Cardiff University, City University of London, University of Cyprus, Istanbul Commerce University, Lancaster University, London Business School, Singapore Management University, and Tel Aviv University for many useful comments and suggestions. (Paper received January 2006, revised version accepted June 2006. Online publication September 2006) Address for correspondence: Eli Amir, London Business School, Regents Park, Sussex Place, London NW1 4SA, UK. e-mail: eamir@london.edu
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impaired when appropriate. The full expensing of R&D expenditures specified in Statement of Financial Accounting Standard No. 2 (SFAS 2) is partly motivated by the argument that it is more difficult to measure subsequent economic benefits resulting from R&D activities than from CAPEX. In this paper, we examine the association between R&D and CAPEX on the one hand and the volatility of subsequent operating profitability. 1 This approach enables us to benchmark R&D against CAPEX and vice versa, so neither R&D nor CAPEX are analysed in absolute terms. To provide a useful context to our analysis, we rank and distinguish between industries according to their R&D-to-CAPEX ratio. This measure captures the relative intensity of the two investment activities in a firms strategy. In industries where R&D is relatively more intensive than CAPEX, that is where R&D is likely to be key to success, we would expect volatility of subsequent profitability to be more closely associated with R&D than CAPEX. In firms where R&D plays a lesser role than CAPEX, such a link is expected to be weaker or even reversed. Recent years have experienced an important shift in the economics of innovation. Specifically, the information age revolution has witnessed an exponential increase in computing power and a steady decrease in the prices of hardware and software. Though this has initially benefited the computer, information technology services, semiconductors and telecommunication industries, it has introduced possibilities for innovation that were not available before elsewhere in the economy. Jorgenson (2001) argues that information technology has produced a fundamental change leading to a permanent improvement in the growth prospects of the United States economy. However, the impact of this revolution has not been uniform across industries. Fast changing businesses whose success depends on the ability to introduce genuinely new products have embraced the new frontiers by increasing spending on R&D in the hope of finding one big winner. But, despite the increase in R&D, genuine innovations are fewer and far between, implying higher degree of risk. 2 In other industries the impact of the information age revolution has not been as dramatic, since R&D is directed at making relatively small improvements to existing products rather than breakthroughs. In such industries, R&D expenditure in recent years has not grown much and the rate of success has remained relatively unchanged. For these industries, investments in CAPEX are likely to be key and hence more closely linked to business risk. Given these differences, we explore whether R&D and CAPEX exhibit different association with risk in recent years than in early years and whether such a difference is more pronounced for firms operating in R&D-intensive industries. To examine these relations we construct a sample including all industries for which we could obtain at least 1,000 firm-year observations with positive R&D expenditures. This is done to ensure that we identify industries with a long-standing strategy of investment in R&D. To this initial sample we add all firm-year observations from the rest of the population with positive R&D expense. The resulting ten sample-industries include traditional ones, such as Rubber & Plastics Products, as well as R&D-intensive ones, such as Computers and Pharmaceuticals. The sample utilizes data from 1972 to 2002 to construct a testing period from 1972 to 1999.

1 Chan et al. (1990), Sougiannis (1994) and Lev and Sougiannis (1996) examine the valuation of R&D expenditures. Kerstein and Kim (1995) examine the valuation effects of capital expenditures. Dukes et al. (1980) and Hirschey and Weygandt (1985) examine the effect of accounting for R&D on R&D activities. 2 Dont laugh at gilded butterflies, Economist (April 22, 2004).
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Using a model similar to that used by Kothari et al. (2002), we find for the entire sample that R&D exhibits greater effect on the variability of future operating income - the measure of a firms underlying risk employed here than CAPEX. However, this result is driven by R&D-intensive industries and generally does not extend to CAPEXintensive industries. Consistent with the history of major technological and scientific developments, analyzing patterns in R&D intensity over time suggests that a major shift occurred in the mid 1980s, especially in R&D-intensive industries. Splitting the sample to an early period (1972-1985) and a late period (1986-1999), we find that the greater association of R&D with variability of subsequent operating income is more pronounced in the late period than for the early period. However, despite the significant increase in relative spending on R&D in the late period by R&D-intensive firms, we find the greater impact of R&D on subsequent earnings variability holds for both periods for these firms. The evidence is also consistent with the idea that in the US economy as a whole there was a shift in the relations between R&D and CAPEX in that the revolution in information technology has also introduced and widened a gap in the risk level associated with these two important activities. Another implication concerns US GAAP for R&D expenditures. Prior research, such as Lev and Sougiannis (1996), has argued for changing GAAP in favor of treating R&D as CAPEX by requiring capitalization of R&D. On the other hand, Kothari et al. (2002) argue against any such capitalization. The evidence presented here is more cautious about either recommendation. Accountants are generally concerned with the risk associated with certain investments so as to disallow capitalization when the risk is too high. Since in R&D-intensive industries the risk associated with R&D is higher than with CAPEX, capitalization of R&D under GAAP may be allowed only in CAPEX-intensive firms where volatility of subsequent operating profitability is equally influenced by R&D and CAPEX. This study proceeds as follows: Section 2 describes the sample selection and research design. Section 3 provides descriptive statistics on the sample and the industries involved. Section 4 provides the results of our analyses and Section 5 provides some concluding remarks.
2. SAMPLE AND RESEARCH DESIGN

(i) Sample Selection

Our initial sample contains data meeting the following requirements. First, it should include only companies with positive R&D spending over the period 1972-2002. Second, it should have sufficient time series data to be possible to calculate the dependent variable used here: the standard deviation of operating income before R&D, advertising, depreciation and amortization over subsequent periods. Third, it should allow us to measure R&D capital, which requires lagged data. Finally, in order to identify industries with long-standing R&D strategy, we require a minimum of 1,000 firm/year usable observations for which the median R&D expense is at least 2% of the market value of the firm. This set of industries encompasses nine industries: (1) Miscellaneous Durables: SIC codes 3000-3399 & 3900-3999. (2) Fabricated Metal and Ex Machinery: SIC codes 3400-3499. (3) Industrial & Commercial Machinery: SIC codes 3500-3599 except 3570-3579.
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(4) Electronic & other Electric Equipment: SIC codes 3600-3699 except 3670-3679. (5) Transportation Equipment: SIC codes 3700-3799. (6) Measurement Instruments, Photo & Watches: SIC codes 3800-3899. (7) Chemicals: SIC codes 2800-2824, 2840-2899. (8) Computers: SIC codes 7370-7379, 3570-3579, & 3670-3679. (9) Pharmaceuticals: SIC codes 2830- 2836. We then augment the sample to include all firm-year observations for which the first three criteria hold. All observations from this search are included in the Other Industries. This is done in order to capture firms conducting R&D even if the industry as a whole is not R&D-intensive, or in cases where R&D is carried out over relatively short periods of time. The augmented sample also enables better comparisons with prior research involving R&D. Variables are measured as follows: CAPEX is capital expenditures (Compustat data #128). RDEX is research and development expense (data #46). ADEX is advertising expense (data #45), with a zero reported amount not treated as a missing value. SIZE is the natural log of market value of equity, MVE, which is measured as the product of fiscal year-end closing share price (item #199), and common shares outstanding (item #54). FLEV is a measure of financial leverage and is measured as long-term debt (item #9), plus current portion of long-term debt (item #34), divided by long-term debt plus current portion of long-term debt plus MVE. OPIN is operating income before depreciation, amortization, advertising and R&D (data #13 + data #45 + data #46).

(ii) Regression Models

Our main analysis is based on two regression models. In the first model, we estimate the association between the standard deviation of future operating income before R&D, advertising, depreciation and amortization and current investments in R&D deflated by lagged market value of equity (DRDEX), current investments in fixed capital deflated by lagged market value of equity (DCAPEX), advertising expenditures deflated by lagged market value of equity (DADEX), financial leverage (FLEV), and firm size (SIZE). We measure the dependent variable by the volatility of future operating income before depreciation, amortization, advertising and R&D (SDFOPIN) per share deflated by beginning of period stock price. Specifically, we calculate standard deviations using data for subsequent five years. If data are not available for the subsequent five years, we compute the variable using current data plus subsequent four years. If this variable is still missing, we use lagged, current and subsequent three years of data. Finally, to reduce the effect of extreme observations, we set values above (below) the 99th (1st ) percentile to be equal to the 99th (1st ) percentile. Equation (1) is thus: SDFOPINit = 0t + 1t DRDEXit + 2t DCAPEXit + 3t DADEXit + 4t FLEVit + 5t SIZEit + it . (1)

This model is similar to that used by Kothari et al. (2002). They offer a test that relates R&D and CAPEX to the volatility of future earnings per share (EPS). Here, in contrast, we use operating income before R&D, advertising depreciation and amortization as the dependent variable. Our measure avoids some confounding effects that are present in EPS. First, future EPS are likely affected by levels of R&D and advertising expenditures
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in the future. This may introduce a source of volatility that is unrelated to current investment strategy. Similarly, effects of future changes in a firms tax environment are stripped out by using adjusted operating income. In addition, depreciation and amortization are susceptible to managerial discretion in accounting policies and, furthermore, by removing these, adjusted operating profit serves as a better proxy for operating cash flows. 3 A positive (negative) coefficient on DRDEX or DCAPEX would suggest that the investment is associated with more (less) risk. Equation (1) ignores past R&D expenditures and capital expenditures, which might affect the variation of future income. Furthermore, annual outlays on R&D and CAPEX may be too small to detect differences that only accumulate over time. We thus use a second model that includes R&D capital deflated by lagged market value of equity (DRDCAP) and net tangible fixed assets deflated by lagged market value of equity (DPPECAP) as independent variables instead of DRDEX and DCAPEX, respectively. To measure R&D capital (RDCAP) we use the method prescribed by Lev and Sougiannis (1996). In particular, we estimate the useful life and amortization rates for each of our ten industries. 4 The estimated model thus is: SDFOPINit = 0t + 1t DRDCAPit + 2t DPPECAPit + 3t DADEXit + 4t FLEVit + 5t SIZEit + it (2)

(iii) Capturing Relative Investment Intensity

Although the 10 industries in this study can be described as R&D-intensive, the degree of intensity is not uniform across industries. Furthermore, the importance of capital expenditures may also vary across industries. The relation between R&D expenses and CAPEX likely captures the relative strategic importance of R&D vs. CAPEX. For example, when innovation is the main driver of profitability, one would expect high ratio of R&D to CAPEX. When innovation is directed at small improvements of existing products or services, a low ratio is expected. We therefore distinguish between industries that exhibit relatively high R&D-intensity combined with relatively low capital intensity, and those that exhibit relatively low R&D-intensity combined with relatively high capital intensity. We define a relative intensity measure calculated as: R&D-CAPEX = median(DRDEX) . median(CAPEXP)

An industry with a ratio above one is relatively more R&D-intensive. If the ratio is below one, we would say that the industry is relatively more capital-intensive.

3 Other potential measures of risk can be return volatility, bid-ask spreads and volatility of cash flows. Data on operating cash flows are not available prior to 1987, which reduces the power of the tests. Market-based measures of risk (e.g., return volatility) are less relevant to the on-going debate on whether R&D expenditures should be capitalized or expensed in financial statements. Adjusted operating income seems to be less prone to accounting measurement problems and is also a reasonable proxy for operating cash flows. We also run tests using returns volatility (see footnote 8). 4 Our sample includes software firms (SIC codes 7370-7372) that are subject to capitalization requirement under SFAS 86 since 1985. Thus, reported OPIN already takes into account capitalization of software costs. We, however, do not make any adjustment, since according to Aboody and Lev (1998) the capitalization rates are small.
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3. DESCRIPTIVE STATISTICS

Table 1 provides descriptive statistics for the entire sample (Panel A) and by industry (Panel B). For the full sample the mean (median) of variability of future operating income, SDFOPIN, is 0.16 (0.10). The range of SDFOPIN is 0.07-0.18 for the mean and 0.05-0.13 for the median, suggesting that the underlying risk is quite different across industries. Mean (median) DRDEX (R&D expenditures over lagged market value of equity) is 0.08 (0.05), reflecting the focus of this study on R&D-intensive industries. The wide range in the means across industries (0.04-0.11) suggests that the importance of R&D activities varies considerably across sample firms. For the entire sample, mean DCAPEX (capital expenditures deflated by lagged market value of equity) is higher than mean DRDEX (0.11 vs. 0.08) as companies spend, on average, more on tangible fixed assets than on R&D. The range in means of DCAPEX is 0.03-0.17, which is wider than that of DRDEX. Deflated advertising expense (DADEX) is relatively small (0.02 for the entire sample), though its mean is quite high for the Chemicals industry. Financial leverage (FLEV) is higher in the Miscellaneous Durables, Metal and Machinery, and Transport Equipment industries than in the Chemicals, Pharmaceuticals and Computers industries, reflecting the greater ability of traditional industries to rely on tangible assets as collateral against debt. Table 2 provides the correlation matrix for the full sample. Several aspects of this table are worth noting. First, the correlations between SDFOPIN and both DRDEX and DCAPEX are positive, suggesting that both types of investment are associated with variability of subsequent operating income. Second, the Pearson and Spearman correlations between R&D expenditures and capital expenditure are 0.28 and 0.26, respectively, suggesting an interaction between the two investment decisions. The positive relation suggests no substitution effect, on average. Third, SIZE is negatively correlated with the measures of variability consistent with the argument that larger firms have more stable earnings and are less risky. Similarly, the positive correlation between leverage (FLEV) and SDFOPIN is consistent with the argument that both leverage and variability of future operating income capture firm risk (Fama and French, 1992 and 1993). It is difficult to identify the period in which the information technology revolution began to affect companies R&D activities and outcome. However, in reviewing the relevant literature (e.g., Christensen, 1997; and Jorgenson, 2001), we note a number of technological and scientific developments which took place in the 1980s. For example, Cisco was founded in 1984 and during 1986 shipped its first products. The modern Internet came into existence during 1985-1987. IBM devised technology that better links LAN traffic between workstations and servers in 1986 while Sun launched its The network is the computer campaign in 1987. In 1990 the World Wide Web was born and the Human Genome project was initiated (and completed in 2003). The prices of memory chips and semi-conductors declined sharply during the 1990s. One would therefore expect the change in R&D investments to manifest itself in the mid to late 1980s or early 1990s.

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Table 1 Descriptive Statistics

Mean 0.16 0.11 0.51 0.08 0.18 0.02 0.22 4.57 Indus. & Commercial Machinery Electronic & Electric Equipment Transport Equipment Instrument, Photo & Watches Chemicals Computers 0.10 0.06 0.29 0.05 0.11 0.00 0.15 4.30 0.17 0.13 0.64 0.09 0.28 0.06 0.22 2.23 0.05 0.03 0.11 0.02 0.05 0.00 0.03 2.90 Pharmaceut. Median Std. Dev. Q1 Q3 0.19 0.13 0.65 0.10 0.22 0.02 0.35 6.05 Others

Panel A: Full Sample Variable

Observ.

SDFOPIN DCAPEX DPPECAP DRDEX DRDCAP DADEX FLEV SIZE

37,263 37,263 37,263 37,263 22,209 37,263 37,263 37,263

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Panel B: By Industry Variable Miscellaneous Durables

Metal & Machinery

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Mean Med. Mean Med. Mean Med. Mean Med. Mean Med. Mean Med. Mean Med. Mean Med. Mean Med. Mean Med.

SDFOPIN DCAPEX DPPECAP DRDEX DRDCAP DADEX FLEV SIZE

0.18 0.17 0.89 0.05 0.13 0.03 0.30 4.26

0.13 0.12 0.60 0.03 0.09 0.00 0.24 4.10

0.16 0.14 0.75 0.04 0.08 0.02 0.30 4.26

0.11 0.10 0.55 0.02 0.05 0.00 0.27 4.11

0.16 0.11 0.56 0.07 0.20 0.02 0.27 4.27

0.11 0.07 0.38 0.05 0.13 0.00 0.22 4.18

0.15 0.09 0.37 0.09 0.23 0.02 0.20 4.09

0.11 0.06 0.24 0.06 0.15 0.00 0.14 3.88

0.18 0.17 0.82 0.09 0.21 0.02 0.33 5.37

0.13 0.12 0.59 0.05 0.13 0.00 0.30 5.50

0.13 0.07 0.30 0.09 0.20 0.01 0.17 3.83

0.09 0.04 0.18 0.06 0.14 0.00 0.11 3.60

0.11 0.11 0.62 0.05 0.14 0.07 0.24 5.42

0.08 0.08 0.43 0.04 0.10 0.00 0.20 5.61

0.16 0.08 0.28 0.11 0.23 0.01 0.14 4.35

0.12 0.05 0.15 0.07 0.15 0.00 0.06 4.14

0.07 0.03 0.15 0.09 0.15 0.01 0.08 5.05

0.05 0.02 0.08 0.06 0.09 0.00 0.03 4.68

0.16 0.15 0.80 0.04 0.13 0.03 0.28 4.98

0.10 0.10 0.54 0.02 0.06 0.00 0.24 4.71

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Table 1 (Continued)

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R&D AND CAPITAL EXPENDITURES

Notes: 1 The table provides descriptive statistics for the entire sample. The sample comprises of companies with positive R&D expenditures and non-missing data that belong to ten identified industries. 2 Variable Definitions: a. SDFOPIN Standard Deviation of Operating Income per Share over five subsequent years deflated by the beginning of the period stock price. We calculate standard deviations using operating income before R&D, advertising, depreciation and amortization. If data are unavailable for the subsequent five years, we calculate the variable using current and subsequent four years. If this variable is still missing, we use lagged, current and subsequent three years of operating income. b. DCAPEX Capital Expenditures (Compustat item 128) divided by lagged market value of equity (item 199 multiplied by item 54). c. DPPECAP Property, Plant and Equipment (Compustat item 8), divided by lagged market value of equity. d. DRDEX Research and Development Expenditures (Compustat item 46) divided by lagged market value of equity. e. DRDCAP Research and Development Capital, divided by lagged market value of equity. R&D Capital is calculated following the industry-specific amortization rate generated by the Almon lag procedure as reported in Table 4. f. DADEX Advertising Expenditures (Compustat item 45), divided by lagged market value of equity. Missing values are set equal to zero. g. FLEV Financial Leverage, measured as long-term debt (Compustat item 9) plus current portion of long-term debt (item 34), divided by long-term debt plus current portion of long-term debt plus the market value of equity. h. SIZE - Natural logarithm of market value of equity (Compustat item 199 multiplied by item 54). i. To reduce the effects of extreme observations, we set values above (below) the 99% (1%) percentile to be equal to the 99% (1%) percentile for all variables. 3 Industries are defined as follows: (1) Miscellaneous Durables: 3000-3399, 3900-3999. (2) Fabricated Metal and Ex Machinery: 3400-3499. (3) Industrial and Commercial Machinery: 3500-3599 except 3570-3579. (4) Electronic and other Electric Equipment: 3600-3699 except 3670-3679. (5) Transportation Equipment 3700-3799. (6) Measurement Instruments, Photo and Watches: 3800-3899. (7) Chemicals: 2800-2824, 2840-2899. (8) Computers: 7370-7379, 3570-3579, 3670-3679. (9) Pharmaceuticals 2830- 2836. (10) Others: all the other firms except the above nine industries.

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Table 2 Correlation Matrix Pearson above and Spearman below the Diagonal
DPPECAP 0.35 0.77 0.21 0.28 0.11 0.69 0.01 0.95 0.11 0.16 0.17 0.11 0.22 0.21 0.35 0.28 0.24 0.37 0.27 0.29 0.93 DRDEX DRDCAP DADEX 0.25 0.18 0.19 0.12 0.15 0.12 0.02 FLEV 0.49 0.49 0.65 0.19 0.24 0.19 0.10 SIZE 0.41 0.02 0.04 0.20 0.22 0.05 0.16

Variable 0.31 0.83 0.26 0.28 0.12 0.54 0.08

SDFOPIN

DCAPEX

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SDFOPIN DCAPEX DPPECAP DRDEX DRDCAP DADEX FLEV SIZE

0.30 0.32 0.37 0.39 0.11 0.42 0.45

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Note: See Table 1 for variable definitions. Correlations above (below) 0.06 (0.06) are significant at the 0.01 level.

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Figure 1 Annual R&D-CAPEX Ratios Per Industry, where R&D-CAPEX Ratio is Measured for Each Industry/Year as Median Annual RDEX Divided by Median Annual CAPEX
14.00 Miscell. Durables 12.00 Metal Machinery Indus. & Comm Machinery Transport Chemicals Electronic & Electric 6.00 Inst. & Photos & Watches 4.00 Computers Pharmaceuticals 2.00 Others 0.00 1972

10.00

R&D/CAPEX

8.00

1979

1986
Year

1993

2000

We have plotted the distribution of R&D relative to CAPEX over time in an attempt to identify when relative R&D intensity has fundamentally changed during the sample period. Figure 1 charts R&D-CAPEX ratios, calculated as medians of R&D expenditures deflated by annual medians of capital expenditure, for sample industries. Until the mid 1980s all industries exhibit similar R&D-CAPEX ratios, as can be seen by the tight cluster of industry lines in the early period. However, after that period, this ratio dramatically increases for the Computer, Measurement Instruments, Photo and Watches, Electronic and other Electric Equipment and Pharmaceutical industries. Furthermore, this ratio has remained quite similar for the other industries. In addition, the R&DCAPEX ratio is quite volatile for the Computer, Measurement Instruments, Photo and Watches, Electronic and other Electric Equipment and Pharmaceutical industries, but relatively smooth for the other industries. This pattern is consistent with a structural change in R&D and innovation strategy in these four highly R&D-intensive industries. This may be attributable to shifts towards more risky R&D strategy by firms whose investment opportunities were expanded following the above-mentioned scientific and information technology breakthroughs. Based on this evidence, we distinguish in our tests between two sub-periods: early period (1972-1985) and late period (1986-1999) and later check whether our results are sensitive to the choice of 1985 as a cutoff point. Table 3 provides descriptive statistics for the level and variability of R&D and capital expenditures by industry and time period. We obtain industry means of deflated R&D (DRDEX) and CAPEX (DCAPEX) by regressing each variable on yearly fixed effects
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Table 3 The Level and Variability of R&D and Capital Expenditures By Industry and Time Period
Miscell. Durables 0.24 0.050 0.003 0.061 0.005 0.039 0.003 3.73 0.040 0.005 0.039 0.032 0.042 0.009 0.09 0.086 0.004 0.110 0.005 0.062 0.005 6.74 0.051 0.004 0.059 0.006 0.043 0.005 2.23 0.071 0.008 0.071 0.011 0.070 0.009 0.07 0.24 0.43 0.48 0.64 1.03 0.088 0.003 0.083 0.005 0.092 0.004 1.55 Metal & Machinery Transp. Equip. Chemical Indus. & Electronic Instrument Computers Pharmac. Commercial & Electric Photo & Machinery Equip. Watches 1.44 0.091 0.003 0.095 0.005 0.088 0.004 1.180 1.50 0.106 0.003 0.099 0.004 0.109 0.001 2.27 3.00 0.091 0.003 0.055 0.004 0.100 0.004 8.23

Panel A: Level Analysis Period

Others

R&D/CAPEX

Full

0.22

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DRDEX

Mean St. Error Early Mean St. Error Late Mean St. Error t (diff. = 0)

Full

0.044 0.002 0.046 0.002 0.042 0.002 1.15

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DCAPEX

Full

Mean St. Error Early Mean St. Error Late Mean St. Error t (diff. = 0)

0.151 0.004 0.202 0.006 0.097 0.004 14.60

0.173 0.009 0.222 0.010 0.125 0.010 6.71

0.142 0.010 0.167 0.010 0.109 0.014 3.39

0.169 0.004 0.215 0.006 0.126 0.005 11.60

0.114 0.004 0.142 0.007 0.087 0.004 6.95

0.105 0.012 0.138 0.015 0.076 0.014 3.02

0.088 0.003 0.124 0.005 0.065 0.002 10.41

0.072 0.007 0.106 0.010 0.053 0.007 4.34

0.084 0.003 0.134 0.006 0.064 0.003 10.33

0.034 0.002 0.057 0.006 0.029 0.002 4.51

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Table 3 (Continued)
Miscell. Durables 0.24 0.030 0.002 0.028 0.003 0.031 0.002 0.93 0.089 0.005 0.103 0.006 0.075 0.006 3.14 0.077 0.006 0.087 0.007 0.065 0.006 2.38 0.085 0.003 0.102 0.005 0.068 0.003 5.71 0.056 0.003 0.066 0.006 0.047 0.002 3.07 0.065 0.006 0.083 0.008 0.049 0.008 3.00 0.055 0.002 0.075 0.005 0.043 0.002 5.62 0.048 0.004 0.069 0.006 0.036 0.005 4.48 0.022 0.002 0.018 0.002 0.027 0.004 2.23 0.046 0.002 0.057 0.003 0.035 0.003 5.51 0.023 0.002 0.024 0.003 0.022 0.003 0.49 0.040 0.004 0.037 0.005 0.042 0.005 0.68 0.054 0.002 0.043 0.003 0.061 0.002 4.84 0.054 0.002 0.050 0.002 0.056 0.002 2.07 0.24 0.43 0.48 0.64 1.03 1.44 1.50 0.072 0.002 0.057 0.003 0.078 0.002 5.91 0.053 0.002 0.080 0.006 0.042 0.002 6.13 Metal & Machinery Transp. Equip. Chemical

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Panel B: Variability Analysis Period

Others

Indus. & Electronic Instrument Computers Pharmac. Commercial & Electric Photo & Machinery Equip. Watches 3.00 0.062 0.002 0.028 0.003 0.070 0.003 11.53 0.024 0.002 0.032 0.006 0.022 0.002 1.55

R&D/CAPEX 0.021 0.001 0.020 0.001 0.022 0.002 0.78

Full

0.22

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R&D

Mean St. Error Early Mean St. Error Late Mean St. Error t (diff. = 0)

Full

R&D AND CAPITAL EXPENDITURES

CAPEX

Mean St. Error Early Mean St. Error Late Mean St. Error t (diff. = 0)

Full

0.085 0.003 0.116 0.004 0.057 0.003 10.78

Notes: 1 DCAPEX Capital Expenditures (Compustat item 128) divided by lagged market value of equity (Item 199 multiplied by item 54). DRDEX Research and Development Expenditures (Compustat item 46) divided by lagged market value of equity. Values above (below) the 99% (1%) percentile are set equal to the 99% (1%) percentile. 2 Industry means of DRDEX and DCAPEX and standard errors are obtained by regressing each variable on yearly fixed effects and clustering on each firm. We repeat this computation separately for each industry and time period. 3 R&D Variability and Capital Expenditure Variability are measured as the standard deviation of R&D or CAPEX expenditures over the past five years for each firm. 4 R&D-CAPEX ratio is measured for each industry/year as median annual R&D Expenditure divided by median annual Capital Expenditure. 5 The t-statistics are for tests of differences between the late period and the early period. A bold font indicates significance at the 0.05 level. 6 Early period is 1972-1985; late period is 1986-1999.

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and clustering on each firm. We repeat this computation separately for each industry and time period. Variability measures are obtained by computing the standard deviation of DRDEX and DCAPEX for each firm during the past five years and then averaged for each industry. We report t-statistics for tests of differences between the early and late means. Panel A shows that, in general, the level of (scaled) R&D expenditure increases with R&D-CAPEX ratio, while the level of (scaled) CAPEX tends to decrease with this ratio, as would be expected. Over the entire sample period, the level of R&D expenditure has increased (significantly at the 0.05 level) in two industries (Computers and Pharmaceuticals), decreased (significantly at the 0.05 level) in three industries (Miscellaneous Durables, Transportation equipment, and Chemical), and stayed relatively stable in the remaining industries. In contrast, the intensity of capital expenditures has uniformly declined in all industries (significant at the 0.05 level). Turning to Panel B, the variability of scaled R&D and capital expenditures also varies across industries and over time. 5 The variability of R&D increases (significantly at the 0.05 level or better) in five of the 10 industries, particularly in the R&D-intensive industries. R&D variability has declined in the Transportation Equipment industry and remained stable in the remaining industries. That both the level and variability of R&D have increased most powerfully in the R&D-intensive industries (e.g., Electronics, Computers and Pharmaceuticals) is consistent with the impact of the information technology revolution on these industries and is suggestive of larger and more risky R&D activities taken by firms in the later period than ever before. Turning to the variability of capital expenditures, it is higher in traditional industries, such as Rubber & Plastic, Transportation Equipment and Metal Machinery, and lower in new economy industries, such as Computers, Electronic & Electric Equipment and Pharmaceuticals. The variability of capital expenditures decreased (significantly at the 0.05 level) in all industries, consistent with the decline in the level of capital expenditures.
4. RESULTS

(i) Estimation of R&D Capital and Amortization Rates

Analysis of equation (2) involves estimation of R&D capital and amortization rates. We follow the estimation procedure used by Lev and Sougiannis (1996), on an industry-by-industry basis. Specifically, we estimate the association between lagged R&D expenditures and current operating income and derive R&Ds total economic benefits for each industry as well as industry specific R&D amortization rates for the entire sample period, early period (1972-1985) and late period (1986-1999). We estimate the following model (using instrumental variables and the Almon lag procedure as in Lev and Sougiannis (1996): (OPIN/S)it = 0 + 1 (TA/S)i,t1 +
k

2,k (RD/S)i,tk + 3 (AD/S)i,t1 + e it , (3)

5 There is a discernable relation between R&D-CAPEX ratio and variability measures whereby R&D (CAPEX) variability is positively (negatively) related to this ratio. Using the 10 industry observations, the Spearman correlation coefficients between R&D-CAPEX ratio and R&D variability is 0.77 and between R&D-CAPEX ratio and CAPEX variability is 0.91.
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235

where OPIN is operating income before depreciation, amortization, R&D, and advertising expenses. S is annual sales, TA is total assets, RD is R&D expenditures, and AD is advertising expenditures. The results, which are reported in Table 4, suggest that the number of significant R&D lags ranges between three and seven. This is slightly less than the reported lags in Table 3 in Lev and Sougiannis (1996) where lags range between four and eight. Also, our estimation procedure yields total economic benefits of R&D ranging between 1.28 and 2.82 for the entire sample period, between 1.31 and 2.69 for the early period, and between 1.49 and 2.83 for the late period. These results are similar to those reported by Lev and Sougiannis (1996)between 1.67 and 2.63 (sample period up to 1991)with Chemicals and Pharmaceuticals yielding the highest benefits. The results suggest, for the entire sample period, that R&D investment is recoverable, on average, as reflected by the sum of the coefficients on lagged R&D being larger than one in all industries. Total return has increased over time in eight of the 10 industries; return to R&D slightly decreased in Industrial & Commercial Machinery industry and in the Measurement Instruments, Photo & Watches industry. Annual amortization rates vary quite considerably across industries and time periods. However, for the entire sample period the useful life of R&D capital is five to seven years. Finally, though the measure of total benefits does not smoothly increase with the R&D-CAPEX ratio, the correlation is positive and relatively large (0.48 for all periods). This suggests that R&D activity is more profitable in R&D-intensive industries than CAPEX-intensive industries.

(ii) The Relative Association of R&D and CAPEX with Earnings Variability
To facilitate comparison with Kothari et al. (2002), we initially estimate equations (1) and (2) using annual cross-sectional regressions and report mean and standard deviation of the coefficients, as in Fama and MacBeth (1973). All coefficients and tstatistics are adjusted for serial correlation using the Newey and West (1987) procedure. Table 5 presents the results of this analysis. At the rightmost column of the panel, we present p-values of the test on the difference between the coefficients on R&D (R&D capital) and capital expenditures (PPE). Estimation of equation (1) for the entire sample-period yields an average coefficient of 0.266 on R&D expenditures (DRDEX). This average coefficient is significantly larger than zero at the 0.01 level. The average coefficient on capital expenditures (DCAPEX) is 0.130, also significantly different from zero. Furthermore, the average coefficient on DRDEX is larger than the average coefficient on DCAPEX and the difference is significant at the 0.01 level. These results are consistent with those reported by Kothari et al. (2002). Similar results are obtained with equation (2), where R&D and fixed capital replace R&D and capital expenditures, respectively. Specifically, the average coefficient on R&D capital is positive and significantly different from zero at the 0.01 level ( 1 = 0.118, t = 14.94); the coefficient on PPECAP is also significantly different from zero at the 0.01 level ( 1 = 0.023, t = 5.99). The difference between the two coefficients is significantly different from zero at the 0.01 level. We also present results for two sub-periods an early period (1972-1985) and a late period (1986-1999). Focusing first on the late period 1986-1999, the coefficient on R&D expenditures is 0.372 (t = 16.83) whereas the coefficient on capital expenditures
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Table 4 R&D Amortization Rates and Total Economic Benefits by Industry

Miscell. Durables 0.24 9.1% 9.1% 22.8% 14.1% 17.4% 28.9% 17.6% 21.7% 31.1% 14.6% 17.5% 19.0% 15.2% 15.3% 17.4% 15.6% 13.5% 14.3% 15.1% 23.2% 20.9% 20.0% 15.4% 19.0% 16.0% 10.9% 9.8% 15.8% 12.8% 11.3% 12.0% 26.3% 19.0% 17.3% 18.0% 17.2% 15.4% 23.5% 18.2% 27.0% 11.6% 17.3% 16.9% 4.3% 1.6% 14.7% 11.6% 7.2% 10.1% 14.6% 14.3% 19.2% 7.3% 14.2% 0.24 0.43 0.48 0.64 1.03 1.44 14.9% 9.2% 15.0% 21.9% 19.7% 25.8% 21.2% 35.1% 21.5% Metal Machinery Trans. Equip. Chemic. Ind & Comm. Mach. Electronics & Electr. Inst. & Photo & Watches Comp. Pharm.

Others

R&D-CAPEX

Full

0.22

1.50 18.0% 3.4% 23.2% 20.9% 14.1% 28.5% 21.2% 20.7% 26.9%

3.00 24.8% 14.5% 4.0% 21.3% 15.7% 11.2% 17.8% 16.1% 16.0%

A 2,0

Full Early Late

7.6% 14.1% 18.8%

A 2,1

Full Early Late

11.1% 22.4% 24.9%

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A 2,2

Full Early Late

21.6% 26.7% 27.1%

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A 2,3

Full Early Late 20.2% 18.5% NS 8.9% 16.3% 14.3% 13.4% 17.9% 21.3%

23.7% 23.3% 21.2%

19.7% 22.1% 17.2%

11.0% 17.7% 17.5%

14.3% 17.6% 21.2%

14.6% 13.8% 16.3% 13.5% 13.6% 17.3%

17.7% 17.0% 20.0% 18.4% 12.4% 16.1%

13.5% 23.8% 17.6% 11.5% 18.8% 17.1%

16.8% 26.4% 14.2% 12.6% 9.6% 10.6%

18.9% 23.4% 18.4% 14.2% 22.0% 3.0%

14.3% 15.8% 18.4% 10.8% 14.7% 18.4%

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A 2,4

Full Early Late

19.2% 13.5% 8.0%

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Table 4 (Continued)
Metal Machinery 8.6% 13.2% 9.6% 9.9% 8.3% 3.3% NS 6.0% 1.1% 1.28 1.46 1.49 2.55 2.32 2.43 2.44 2.21 2.59 1.82 1.87 1.80 NS 10.2% NS 5.80% NS NS 2.39 1.79 2.45 1.69 1.81 1.68 1.58 1.31 1.74 11.7% 12.1% 10.1% 13.0% 11.8% 16.3% 10.5% NS NS 7.7% NS 5.2% 12.5% 16.0% 17.6% 12.7% 12.9% 17.3% 16.2% 6.6% 9.7% 9.6% 8.6% 10.5% 12.5% NS 12.9% Trans. Equip. Chemic. Ind & Comm. Mach. Electronics & Electr. Inst. & Photo & Watches Comp. Pharm.

Others

Miscell. Durables

A 2,5

Full Early Late

16.8% NS NS

19.3% 11.0% NS

6.8% 16.5% NS

7.2% 12.9% 16.1% 3.7% 10.3% 11.4% NS NS 4.4% 2.82 2.69 2.83

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A 2,6

Full Early Late

A 2,7

Full Early Late

R&D AND CAPITAL EXPENDITURES

Total benefit

Full Early Late

1.53 1.34 1.59

1.58 1.57 1.78

Notes: 1 See Table 1 for industry classification. 2 Early period is 1972-1985; late period is 1986-1999. 3 NS Not Significant at the 0.10 level.

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Table 5 Cross Sectional (Fama-Macbeth) Annual Regressions

DCAPEX DRDCAP DPPECAP DADEX FLEV SIZE R 2 /N p-value 0.00 0.14 0.00 0.00 0.09 0.00

DRDEX 0.130 8.45 0.096 5.70 0.161 9.34 0.118 14.94 0.042 8.50 0.156 10.24 0.023 5.99 0.024 4.66 0.023 4.07 0.375 8.81 0.299 8.35 0.446 7.80 0.366 11.08 0.301 27.95 0.399 8.48 0.256 15.00 0.277 23.20 0.237 10.00 0.235 17.40 0.241 28.72 0.232 12.22 0.021 17.44 0.023 12.89 0.019 17.36 0.018 18.91 0.019 22.29 0.018 15.62 0.33 1,380 0.37 1,157 0.29 1,587 0.35 1,058 0.38 929 0.34 1,123

Equation (1) - Full Sample t-statistic Equation (1) - Early Period t-statistic Equation (1) - Late Period t-statistic Equation (2)- Full Sample t-statistic Equation (2) - Early Period t-statistic Equation (2) - Late Period t-statistic

0.266 20.60 0.152 11.32 0.372 16.83

AMIR, GUAN AND LIVNE

Notes: 1 This table presents average coefficients and standard errors from annual cross-sectional regressions. The dependent variable is Standard Deviation of Future Operating Income before R&D, Depreciation, Amortization and Advertising (SDFOPIN). The models are:

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(1) SDFOPINit = 0t + 1t DRDEXit + 2t DCAPEXit + 3t DADEXit + 4t FLEVit + 5t SIZEit + it ,

(2) SDFOPINit = 0t + 1t DRDCAPit + 2t DPPECAPit + 3t DADEXit + 4t FLEVit + 5t SIZEit + it .

2 For variable definitions, see Table 1. 3 Early period - 1972-1985 (1979-1985 for

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4 Number

the second equation); late period 1986-1999. of observations represents annual average. 5 All reported t-statistics are adjusted for serial correlation in the estimated coefficients on the standard deviation using the Newey-West (1987) procedure allowing a maximum of five lags for the entire sample, and two lags for the early/late period samples. We report p-values of the test that 1 = 2 in equation (1), and the test that 1 = 2 in equation (2).

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Figure 2 Annual Coefficients on R&D Expenditures ( 1 ) and Annual Coefficients on Capital Expenditures ( 2 ) Extracted from the Following Model where the Dependent Variable is the Standard Deviation of Future Operating Income Before R&D, Advertising, Depreciation and Amortization SDFOPINit = 0t + 1t DRDEXit + 2t DCAPEXit + 3t DADEXit + 4t FLEVit + 5t SIZEit + it
0.5

0.4

0.3 R&D Coefficients CAPEX Coefficients 0.2

0.1

0
73 76 79 85 88 91 94 19 19 82 19 19 19 19 19 19 19 97

is 0.161 (t = 9.34). The difference is significant at the 0.01 level. As for the early period (1972-1985), both coefficients are positive and significant, but the difference is not significant at the 0.10 level. This is also the case when R&D capital and PPE are used instead of R&D expense and capital expenditures, respectively. However, the stronger association of R&D capital than PPE holds in the early period with a difference significant at the 0.10 level (p-value = 0.09). To summarize, it is mostly the later period in which R&D contributes more than physical capital investment to the variability of future adjusted operating income. Figure 2 graphically depicts the pattern in the annual coefficients on R&D expense and CAPEX (not tabulated). For the first 10 years there is no clear pattern suggesting that R&D contributes more than CAPEX to the variability of operating income. The graph shows that thereafter R&D contributes more than CAPEX to the variability of operating income. The magnitude of the difference between the coefficient on R&D and that on CAPEX is particularly high in the mid 1980s and throughout most of the 1990s. Figure 3 graphically depicts the pattern in the annual coefficients on R&D capital and PPE. Similar to Figure 2, the coefficient on R&D capital becomes much larger than the coefficient on PPE from the mid 1980s onward. Before that, we do not observe any systematic difference between the two coefficients.
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Figure 3 Annual Coefficients on R&D Capital ( 1 ) and Annual Coefficients on Property Plant and Equipment ( 2 ) Extracted from the Following Model where the Dependent Variable is the Standard Deviation of Future Operating Income Before R&D, Advertising, Depreciation and Amortization SDFOPINit = 0t + 1t DRDCAPit + 2t DPPECAPit + 3t DADEXit + 4t FLEVit + 5t SIZEit + it
0.25

0.2

0.15

R&D Capital Coefficients PP&E Coefficients

0.1

0.05

0
83 19 85 19 87 19 89 19 91 19 93 19 95 19 97 19 99 79 19 81 19 19

While using the methodology of Fama and Macbeth (1973) corrects for cross sectional dependence in errors, serial correlation in errors, caused by the overlapping nature of the dependent variable and non stationarity in independent variables, could still bias the standard errors downward and overstate the t-statistics. We address this concern using the methodology suggested by Petersen (2005). First, we assess the bias in standard errors caused by cross-sectional dependence (i.e., time effect) and by serial correlation (i.e., firm effect) by comparing the robust standard errors clustered by time and the robust standard errors clustered by firm, respectively, with White standard errors. We conduct this investigation for each of our industry and period sub-samples separately. The results of this initial analysis suggest that robust standard errors clustered by firm are larger than White standard errors, implying the presence of a firm effect. In contrast, the robust standard errors clustered by time are very similar to White standard errors, implying that time effects have only a secondary effect on our analysis. Consequently, we re-estimate equations (1) and (2) using yearly fixed effects to control
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for time effects and clustering for each firm to control for firm effects. 6 The results of this estimation method are reported in Table 6. As Table 6 indicates, while the coefficients are very similar to those reported in Table 5, the t-statistics are indeed lower. This is consistent with the existence of bias in the standard errors that were reported in Table 5. Still, inferences are largely unaffected. The coefficients on R&D expenses (capital) are larger than those on capital expenditures (PPE) at the 10% level or better. The differences in the coefficients are significantly larger in the late period than in the early one, as reflected in the reported p-values. Table 7 provides the main result of this study industry-specific analysis obtained using the estimation method suggested by Petersen (2005). We rank industries according to R&D-CAPEX ratio and also according to R&D-to-market value of equity, which is consistent with prior literature. Though the ranking is not identical for the two measures, it is quite similar. The table shows that the coefficients on DRDEX and DRDCAP ( 1 in equation (1) and 1 in equation (2)) are consistently positive and significantly larger than zero only in the four industries for which R&D-CAPEX ratio exceeds one for the full estimation period. Moreover, the association in these industries for the full sample period is higher for DRDEX and DRDCAP than for DCAPEX and DPPECAP, respectively, as reflected in the reported p-values. This result suggests that R&D is a greater source of uncertainty in future operating income than capital expenditures only in industries that are relatively more R&D-intensive. As for the relatively CAPEX-intensive industries, there is little evidence that R&D contributes more than physical assets to the variability of future operating income. The inter-temporal analysis reveals that these relations are not influenced by any particular period in a systematic manner. Note that in these industries the coefficients on physical assets, 2 and 2 , tend to be positive and significant. There is no evidence that there are important differences across periods, though. In summary, the results in Table 7 suggest that investments in R&D contribute more than investments in physical assets to the variability of future operating income mostly in industries for which R&D is relatively more intensive than physical assets and particularly in the late period. 7 In industries that are relatively CAPEX-intensive, we find little evidence that R&D contributes more than physical assets to the variability of

6 We also estimated equations (1) and (2) after clustering for each firm and for each year obtaining similar results. 7 1985 is assumed as the cut-off between the early period and the late period. As the information technology revolution was in full swing only during the 1990s, we redefined the early period as 1972 to 1990 and the late period as 1991-1999. The results are very similar to those reported in Table 6. In particular, the positive differences between 1 and 2 as well as between 1 and 2 in the early period are now more significant. Also, the industry analysis is consistent with the findings reported in Table 7. In addition, Table 3 indicates that R&D and CAPEX variability vary across industries and over time. To the extent that the variability measures act as correlated omitted variables, it is necessary to examine whether our previous results are robust to the inclusion of these variables. We find that the variability of R&D and physical assets is positively and significantly related to subsequent earnings variability. However, there is little effect on the results reported in Tables 6 and 7. Furthermore, we repeated our tests after capitalizing and amortizing advertising expenses over a period of three years using a straight line method. The results are very similar to those reported in Tables 6 and 7.
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Table 6 Estimating Equations (1) and (2) Using Year Fixed-Effects and Clustering by Firm
DCAPEX DRDCAP DPPECAP DADEX FLEV SIZE R 2 /N p-value 0.03 0.10 0.00 0.00 0.06 0.00

DRDEX 0.122 6.04 0.150 4.92 0.101 4.36 0.098 10.31 0.060 5.49 0.108 9.40 0.019 2.89 0.022 3.08 0.017 2.07 0.351 9.64 0.309 6.85 0.421 7.95 0.337 8.88 0.299 5.83 0.373 7.57 0.257 26.37 0.278 20.55 0.238 18.15 0.239 16.81 0.245 11.19 0.236 13.67 0.021 24.25 0.023 19.95 0.020 18.94 0.018 17.48 0.019 13.06 0.018 15.28

Equation (1) - Full Sample t-statistic Equation (1) - Early Period t-statistic Equation (1) - Late Period t-statistic Equation (2) - Full Sample t-statistic Equation (2) - Early Period t-statistic Equation (2) - Late Period t-statistic

0.256 12.40 0.204 6.71 0.268 11.17

0.35 4,174 0.39 2,226 0.30 3,222 0.35 2,595 0.37 1,317 0.34 2,134

AMIR, GUAN AND LIVNE

Notes: 1 This table presents coefficients and standard errors for the following models:

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(1) SDFOPINit = 0t + 1t DRDEXit + 2t DCAPEXit + 3t DADEXit + 4t FLEVit + 5t SIZEit + it ,

(2) SDFOPINit = 0t + 1t DRDCAPit + 2t DPPECAPit + 3t DADEXit + 4t FLEVit + 5t SIZEit + it .

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2 The

dependent variable is Standard Deviation of Future Operating Income before R&D, Depreciation, Amortization and Advertising (SDFOPIN). See Table 1 for variable definitions. Early period - 1972-1985 (1979-1985 for the second equation); late period 1986-1999. We report p-values of the test that 1 = 2 in equation (1), and the test that 1 = 2 in equation (2). 3 We estimate equations (1) and (2) for the panel data after including yearly fixed effects and clustering on each firm. N represents the number of clusters (firms) for each regression.

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Table 7 Association of R&D Relative to CAPEX with the Variability of Future Operating Income by R&D/CAPEX and R&D/MV Ratios
R&D/ CAPEX 3.00 1.02 4.20 0.38 0.45 0.31 0.31 0.32 0.30 0.26 0.53 0.11 0.26 0.28 0.26 0.20 0.12 0.22 0.10 0.17 0.31 0.25 0.22 0.35 0.08 0.14 0.03 0.05 0.03 0.10 0.28 0.18 0.45 0.03 0.02 0.07 0.04 0.02 0.08 0.01 0.00 0.01 0.00 0.01 0.01 0.05 0.27 0.04 0.31 0.08 0.15 0.84 0.83 0.42 0.05 0.04 0.07 0.00 0.03 0.00 0.10 0.14 0.09 0.13 0.09 0.14 0.11 0.09 0.17 0.03 0.03 0.08 0.06 0.04 0.08 0.11 0.07 0.13 0.10 0.09 0.11 0.00 0.00 0.05 0.14 0.16 0.13 1.50 0.70 2.06 1.44 0.98 1.88 1.03 0.64 1.42 0.64 0.50 0.78 0.48 0.78 0.51 0.43 0.42 0.42 0.032 0.039 0.028 0.028 0.032 0.025 0.044 0.045 0.044 0.054 0.046 0.060 0.059 0.056 0.062 0.076 0.058 0.077 0.076 0.032 0.080 R&D/ MV 1 p-value 2 1 2 0.02 0.02 0.01 0.05 0.03 0.06 0.01 0.01 0.02 0.00 0.00 0.02 0.02 0.02 0.03 0.02 0.03 0.02 0.08 0.04 0.10 p-value 0.00 0.00 0.01 0.00 0.02 0.00 0.00 0.24 0.00 0.00 0.11 0.00 0.20 0.95 0.17 0.77 0.54 0.45 0.41 0.39 0.86

Period

Industry

Full Early Late

Pharmaceuticals

Full Early Late

Computers

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Full Early Late

Instr. Photo & Watches

Full Early Late

Electronics & Electric.

R&D AND CAPITAL EXPENDITURES

Full Early Late

Indust Comm. Machinery

Full Early Late

Chemicals

Full Early Late

Transportation Equipment

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Table 7 (Continued)
R&D/ CAPEX 0.24 0.21 0.28 0.24 0.21 0.28 0.22 0.16 0.42 0.18 0.11 0.22 0.21 0.08 0.27 0.022 0.019 0.024 0.35 0.23 0.25 0.026 0.025 0.026 0.31 0.41 0.26 0.07 0.12 0.00 0.24 0.19 0.30 0.17 0.02 0.26 0.09 0.06 0.14 0.032 0.035 0.028 0.02 0.09 0.07 0.10 0.05 0.19 0.16 0.10 0.34 0.02 0.04 0.04 R&D/ MV 1 p-value 2 1 2 0.05 0.07 0.04 0.13 0.11 0.15 0.05 0.02 0.06 p-value 0.67 0.40 0.98 0.75 0.25 0.22 0.75 0.85 0.53

Period

Industry

Full Early Late

Miscellaneous Durables

Full Early Late

Metal Machinery

Full Early Late

Others

AMIR, GUAN AND LIVNE

Notes: 1 The table presents coefficients and t-statistics of tests of differences between the coefficient on R&D expenditures (R&D Capital) and capital expenditures (PPE Capital). The dependent variable is Standard Deviation of Future Operating Income before R&D, Depreciation, Amortization and Advertising (SDFOPIN). 2 R&D/CAPEX ratio is measured for each industry as median annual R&D expense divided by median annual capital expenditure, and R&D/MV ratio is measured for each industry as median annual R&D expense divided by median fiscal-year-end market value of the firm. 3 To obtain the coefficients, we estimate annual cross-sectional regressions for two models:

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SDFOPINit = 0t + 1t DRDEXit + 2t DCAPEXit + 3t DADEXit + 4t FLEVit + 5t SIZEit + it ,

SDFOPINit = 0t + 1t DRDCAPit + 2t DPPECAPit + 3t DADEXit + 4t FLEVit + 5t SIZEit + it .

We estimate these models with yearly fixed effects and after clustering on each firm.

4 For other variable definitions, see Table 1. 5 Coefficients and p-value in bold represent significance

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6 Early

at the 0.05 level. period - 1972-1985 (1979-1985 for the second equation); late period 1986-1999.

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245

future operating income. 8 Also, in these industries we do not detect any inter-temporal differences at the individual industry level.
5. CONCLUDING REMARKS

We estimate the association of investments in R&D and in physical assets with the variability of subsequent operating income. The information technology revolution and the emergence of the New Economy industries in the mid-1980s, motivate us to explore whether traditional relations between R&D and physical assets vary across industries and whether these relationships have fundamentally changed over time. We therefore examine the association between R&D and physical assets on one hand and variability of future operating income in different industries and over two distinct time periods. We find that, on average, R&D contributes to the variability of subsequent operating income more than physical assets. However, this result holds only in industries where R&D is relatively more intensive than physical capital. In relatively physical assetsintensive industries, we do not find similar relations. Collectively, the findings indicate that with respect to risk, fundamental differences between investment information about R&D and CAPEX exist. However, they are mainly noticeable in R&D-intensive industries. The evidence also suggests there was a shift in the mid-1980s in the relations between R&D and CAPEX in that the information technology revolution has widened a gap in the risk level associated with these two important investment activities. Our findings have implications for accounting for R&D expenditures. Uniform expensing of R&D expenditures under US GAAP is perhaps overly conservative because in industries where R&D is less intensive than physical capital, R&D activities are not necessarily more risky than physical capital. Our results support the notion of R&D capitalization under certain circumstances, which is consistent with International Financial Reporting Standards (IFRS).
REFERENCES
Aboody, D. and B. Lev (1998), The Value Relevance of Intangibles: The Case of Software Capitalization, Journal of Accounting Research, Vol. 36 (Supplement), pp. 16191. Chan, S., J. Martin and J. Kensinger (1990), Corporate Research and Development Expenditures and Share Value, Journal of Financial Economics, Vol. 26, pp. 25576. Christensen, C. M. (1997), The Innovators Dilemma (HBS Press, Boston, Massachusetts). Dukes, R. E., T. R. Dyckman and J. A. Elliott (1980), Accounting for Research and Development Costs: The Impact on Research and Development Expenditures, Journal of Accounting Research, Vol. 18 (Supplement), pp. 126. Fama, E. and K. French (1992), The Cross-section of Expected Returns, Journal of Finance, Vol. 47, pp. 42765.
8 We also conducted analysis using subsequent monthly stock return variability as the dependent variable instead of subsequent operating income variability. We measured return variability using 36 monthly stock returns subsequent to fiscal year t. In addition to deflated R&D, deflated CAPEX, deflated advertising expenses, financial leverage and size, we added (i) Book-to-Market (B/M it ) and (ii) variability of subsequent operating income (SDFOPIN it ) as control variables. The purpose of this analysis is to check whether our results hold for a more general measure of firm risk and after controlling for variability of subsequent operating income. We find that the results of this analysis are very similar to those reported in Tables 6 and 7. In particular, for the total sample, the coefficients on R&D are, on average, larger than those on CAPEX (at the 0.01 level). This result holds in the five industries with the largest R&D-CAPEX ratio but not in the other industries.
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Fama E. and K. French (1993), Common Risk Factors in the Returns of Stocks and Bonds, Journal of Financial Economics, Vol. 33, pp. 356. and J. Macbeth (1973), Risk, Return, and Equilibrium: Empirical Tests, Journal of Political Economy, Vol. 81, pp. 60736. Hirschey, M. and J. Weygandt (1985), Amortization Policy for Advertising and Research and Development Expenditures, Journal of Accounting Research, Vol. 23, pp. 32685. Jorgenson, D. W. (2001), Information Technology and the U.S. Economy, The American Economic Review, Vol. 91, No. 1, pp. 132. Kerstein, J. and S. Kim (1995), The Incremental Information Content of Capital Expenditures, The Accounting Review, Vol. 70, No. 3, pp. 51326. Kothari, S. P., T. E. Laguerre and A. J. Leone (2002), Capitalization versus Expensing: Evidence on the Uncertainty of Future Earnings From Capital Expenditures versus R&D Outlays, Review of Accounting Studies, Vol. 7, No. 4, pp. 35582. Lev, B. and T. Sougiannis (1996), The Capitalization, Amortization, and Value-relevance of R&D, Journal of Accounting Economics, Vol. 21, pp. 10738. Newey, W. K. and K. D. West (1987), A Simple, Positive Semi-definite Heteroscedasticity and Autocorrelation Consistent Covariance Matrix, Econometrica, Vol. 55, pp. 7038. Petersen, M. A. (2005), Estimating Standard Errors in Finance Panel Datasets: Comparing Approaches, NBER Working Paper W11280 (Kellogg School, Northwestern University). Sougiannis, T. (1994), The Accounting Based Valuation of Corporate R&D, The Accounting Review, Vol. 69, pp. 4468.

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