1042-2587-93-172$1.50 Copyright 1993 by Baylor University Financial Factors Which Stimulate Innovation David Brophy Joel Shulman Because Innovation requires the commitment of resources to a development with hlghly uncertain net returns, the methodology of flnanclal economics Is useful In understanding Innovation, even to the point of suggesting a relatlonshlp between the Incidence and rate of Innovation and the state of key flnanclal factors. Our model posits such a relatlonshlp, grouping the key flnanclal factors under the headings of Investment valuatlon and flnanc· Ing: the fundamental components of flnanclal economics. The model argues that the Incl· dence and rate of Innovation are related to both valuatlon and financing factors as well as the Interactions between them. We present a structure for this model and suggest a LISREL methodology for emplrlcally testing these flnanclal factors. Financial factors generally define innovation feasibility and attractiveness and often determine the survival of the innovating entity. 1 Our model of financial factors, described below, provides a general foundation which, we believe, stimulates innova- tion and leads to organizational growth, development, and profitability. The two primary financial factors that encourage innovation are the analysis and measurement of invest- ment opportunity and financing. The seminal articles of Modigliani and Miller (1958), Sharpe (1964), Lintner (1965), Fama (1970), Black (1973), and Ross (1976) provide insight on these factors. Our model of innovation, leading to organizational growth and producUprocess development and profitability, consists of two endogenous variables- valuation and financing-and six exogenous variables-regulatory environment, cost reduction, tax rates, timing of cash payments, availability of capital, and agency costs. Some of these variables are positively related to innovation and organizational devel- opment, while others have a negative relationship. Moreover, some variables are pre- sumed to have a high covariance with each other. The model we present illustrates variable interactions and potential causality. The model can be tested with standard empirical methodology, such as LISREL, and is consistent with academic literature. In the next section we provide academic support for our first endogenous variable, VAL- UA TION, and describe the three exogenous components. We will then describe our second endogenous variable, FINANCING, and also provide support for the three sub- factors. The following section illustrates the structural equations of our model, and discusses variable relationships and interactions. Finally, we conclude with a discussion of potential methodology and research agenda. l. In this paper we use "entity" to encompass both individual and corporate innovators. Winter, 1993 61