Optimal Investment, Tobin's q, and Cash Flow: Does Unobserved Productivity Matter?

Abstract

We revisit the classical relationship between a firm's investment and Tobin's q, for which unobserved productivity is another important factor of the firm's investment decision, derived from the firm's optimization problem. Our model synthesizes two classical theories of investment decision, Olley and Pakes (1996)'s optimal investment in the production function and the neoclassical q theory of investment. In our setting, besides the potential measurement problem of Tobin’s q, controlling this unobserved productivity becomes a new challenge. We develop an estimation method that tackles both econometric issues given timing and information set assumptions. Using 15,079 unique public firms in the U.S. from 1975 to 2017, we find that cash flow remains a significant factor of investment even after controlling for productivity and that investment becomes less sensitive to q and more sensitive to cash flow.

Keywords: Investment, Tobin's q theory, unobserved productivity, cash flow, endogeneity, measurement error

JEL Classification: C18, D24, D25, G31, O34