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.