Financial cash flows and research and development investment

• This paper investigates how improvement in financial cash flows affects R&D.
• We use a sample of Japanese manufacturing firms for the fiscal years 2001 to 2011.
• Japanese firms increased cash balances and reduced debt dramatically in this period.
• We find that changes in financial cash flows have large impacts on R&D.
• Reductions in interest payments will enhance R&D.

This paper empirically investigates how improvement in financial cash flows affects firms' research and development (R&D) investment using a sample of Japanese manufacturing firms where firms substantially increased cash holdings and reduced outstanding debt. We find that R&D–cash flow sensitivity among financially constrained firms is larger for financial cash flows than for operating cash flows. We also find that among financial cash flows, income gains/losses rather than capital gains/losses significantly affect R&D. These results suggest that improvement in financial cash flows enhance R&D investment by improving the predictable components of cash flows. Furthermore, the results show that decreases in interest payments, rather than increases in interest and dividends income, enhance R&D.