Journal Article

How <i>Q</i> and Cash Flow Affect Investment without Frictions: An Analytic Explanation

Andrew B. Abel and Janice C. Eberly

in The Review of Economic Studies

Published on behalf of Review of Economic Studies Ltd

Volume 78, issue 4, pages 1179-1200
Published in print October 2011 | ISSN: 0034-6527
Published online March 2011 | e-ISSN: 1467-937X | DOI: http://dx.doi.org/10.1093/restud/rdr006
How Q and Cash Flow Affect Investment without Frictions: An Analytic Explanation

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  • Macroeconomics: Consumption, Saving, Production, Employment, and Investment
  • Corporate Governance

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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 Q, and both responses are of empirically plausible magnitudes.

Keywords: Investment; Tobin's Q; Cash Flow; E22; G31

Journal Article.  9999 words. 

Subjects: Macroeconomics: Consumption, Saving, Production, Employment, and Investment ; Corporate Governance

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