Financing constraints and investments in R&D: Evidence from Indian manufacturing firms

•We investigate the financing of R&D expenditure by Indian listed firms.•Cash flow sensitivity is found to be higher in the case of small and young firms.•R&D cash flow sensitivity is found to be significant among business group affiliated firms.•Indian firms do not seem to finance R&D using equity issuances even during the period of active equity market.

This study examines the extent to which financing constraints affect the research and development (R&D) expenditure of Indian manufacturing firms during the period 1991–2011. Using dynamic R&D investment model, we find significant positive relationship between a firm's R&D expenditure and internal cash flow. We lend support to the financing constraint hypothesis by showing higher cash flow sensitivity for small and young firms. Further, we explore the effect of business group affiliation and financial market liquidity on the relationship between financial factors and investments in R&D. We fail to find any significant advantage for group-affiliated firms, indicating ineffectiveness of business groups in alleviating financial constraints. Further, we observe that sample firms do not use external equity to finance their R&D even during periods of hot-equity market and are not engaging in R&D smoothing using cash reserves.