Narrow Results

The greater the firm-specific risk, the more valuable are the innovative opportunities underlying the growth options, and the greater the innovation rent. We examine whether firm-specific risk drives the firm’s innovation rent. We find that the firm-specific risk positively moderates the association between firm innovativeness and firm surplus. Innovation rent is the change in firm surplus per unit change in the knowledge capital (accumulated R&D stock). The firm surplus is the excess market value of the firm over shareholder expectations. We further examine whether the growth options embedded in the firm’s assets mediate the association between firm innovativeness and firm surplus. Growth options positively mediate the association between knowledge capital and firm surplus. The firm-specific risk enhances the value of innovative opportunities underlying the firm’s growth options that are exercised such that the firm earns a value surplus. Our results are consistent with the strategic rent model and emerging behavioural theory.

We develop a model in which the opportunity for a firm to upgrade its technology to the frontier (at a cost) leads to growth options in the firm's value; that is, a firm's value is the sum of value generated by its current technology plus the value of the option to upgrade. Variation in the technological frontier leads to variation in firm value that is unrelated to current cash flow and investment, though variation in firm value anticipates future upgrades and investment. We simulate this model and show that, consistent with the empirical literature, in situations in which growth options are important, regressions of investment on Tobin's Q and cash flow yield small positive coefficients on Q and larger coefficients on cash flow. We also show that growth options increase the volatility of firm value relative to the volatility of cash flow.