While many studies report that R&D investments significantly contribute to firm value, little existing research investigates the effect of the reduction in R&D expenditures on firm value. This paper examines the long-term performance following significant R&D decreases. We find that, contrary to conventional wisdom, R&D decreases enhance rather than destroy shareholder value. We explore three potential economic motives behind R&D decreases -- R&D spillover, managerial myopia, and overinvestment. We find no compelling evidence to support either the spillover or myopia explanation. However, our results suggest that operating performance deteriorates immediately preceding R&D decreases and firms with low or decreasing investment opportunities outperform; these findings strongly support the overinvestment hypothesis. We also show that the cost of capital declines after R&D decreases. However, the market seems to underestimate the improvement in cost of capital following R&D reductions.postprintThe 2010 China International Conference in Finance (CICF 2010), Beijing, China, 4-7 July 2010
