We construct a theoretical model to examine the optimal investments in R&D. The optimal level of investment in R&D is determined by three factors: (i) the expected increase in profitability, (ii) the critical level of accumulated knowledge, and (iii) the Firms's risk tolerance. An expected increase in profitability has a positive effect on investment in R&D, and firms's risk tolerance for the future cash-flow induces to in-
crease the R&D investment. Also, the critical level of accumulated investment in R&D is positively related with the investment in R&D. Our empirical analysis supports our theoretical findings. Using the Compustat database, we find that in the high-tech sector, next period's profitability increase is positively correlated with R&D intensity, and the cash holdings is also positively correlated with R&D intensity. Firm size negatively conditions these relationships.
JEL classification: G11; C61; O32;
Keywords: Optimal investment, R&D, Profitability
