Essays in firm financing and innovation activity

This dissertation is motivated by stark trends in innovation activity and external financing use among U.S. public corporations over the period 1976 to 2005. In the first chapter, I document a drastic reallocation of innovation activity from large to small manufacturing firms. I relate the rise in innovation intensity of small firms to their increased use of external equity financing. Next, I establish that two financial changes, decreased costs of issuing equity and tax rates on corporate distributions, are quantitatively important drivers of the innovation and equity trends. To do so, I build a theoretical model with firm dynamics, in which heterogeneous firms choose innovation efforts and finance their R&D via internal and costly external funds. In the absence of taxes and external financing costs, the model generates a negative relationship between innovation incentives and firm size, inducing a disproportionate investment in R&D by small firms. Introducing these frictions into the model disrupts this monotonic relationship. The model, estimated using firm-level data, is able generate a sizable rise in innovation intensity and equity financing use among small firms as a result of changes in dividend tax rates and equity issuance costs.;Chapter 2 instead focuses on the relationship between firm capital structure and risk, motivated by the decline in leverage of innovative firms since the late 1970's. Using patent statistics, this chapter establishes new empirical facts that relate firm leverage and risk associated with undertaking innovation projects. A theoretical model of equilibrium capital structure and investment choice is used to parse apart the specific contributions of two possible explanations of this leverage phenomenon: tax changes/financial deregulation in equity markets and increased risk of available project. The calibrated model suggests that both forces are at work, but that effective costs associated with issuing equity must have fallen by 31.2 percent while project risk only increased by 4.7 percent.