How Q and Cash Flow Affect Investment without Frictions: An Analytic Explanation

We derive a closed-form solution for Tobin's Q in a stochastic dynamic framework. We show analytically that investment is positively related to Tobin's Q and cash flow, even in the absence of adjustment costs or financing frictions. Both Q and investment move in the same direction as expec...

Full description

Saved in:
Bibliographic Details
Published in:The Review of economic studies 2011-10, Vol.78 (4), p.1179-1200
Main Authors: ABEL, ANDREW B., EBERLY, JANICE C.
Format: Article
Language:English
Subjects:
Access to credit
Business investment
Capital formation
Capital investments
Capital stock
Capital stocks
Cash flow
Coefficients
Corporate finance
Costs
Economic models
Financial investments
Financial management
Financing methods
Investment policy
Investment value
Net investment
Research papers
Revenue
Stochastic models
Studies
User costs
Citations: Items that this one cites
Items that cite this one
Online Access:Get full text
Tags: Add Tag
No Tags, Be the first to tag this record!
Description
Summary:We derive a closed-form solution for Tobin's Q in a stochastic dynamic framework. We show analytically that investment is positively related to Tobin's Q and cash flow, even in the absence of adjustment costs or financing frictions. Both Q and investment move in the same direction as expected revenue growth, so changes in expected revenue growth induce Q and investment to comove positively. Similarly, shocks to current cash flow, arising from shocks to the user cost of capital in our model, cause investment and cash flow per unit of capital to comove positively. Furthermore, we show that this alternative mechanism for the relationship among investment, Q, and cash flow delivers larger cash flow effects for smaller-and faster-growing firms, as observed in the data. Moreover, the empirically small sensitivity of investment to Tobin's Q does not imply implausibly large adjustment costs in our model (since there are no adjustment costs). Calibrating the model generates values of Q similar to those in the data; investment is more sensitive to cash flow than it is to ß, and both responses are of empirically plausible magnitudes.
ISSN:0034-6527
1467-937X
DOI:10.1093/restud/rdr006