Financial Frictions Investment and Tobin's q
Northwestern University; National Bureau of Economic Research (NBER)
April 25, 2007
MIT Department of Economics Working Paper No. 07-16
We develop a model of investment with financial constraints and use it to investigate the relation between investment and Tobin's q. A firm is financed partly by insiders, who control its assets, and partly by outside investors. When their wealth is scarce, insiders earn a rate of return higher than the market rate of return, i.e., they receive a quasi-rent on invested capital. This rent is priced into the value of the firm, so Tobin's q is driven by two forces: changes in the value of invested capital, and changes in the value of the insiders' future rents per unit of capital. This weakens the correlation between q and investment, relative to the frictionless benchmark. We present a calibrated version of the model, which, due to this effect, generate realistic correlations between investment, q, and cash flow.
Number of Pages in PDF File: 33
Keywords: Financial constraints, investment, Tobin's q, limited enforcement.
JEL Classification: E22, E30, E44, G30
Date posted: April 30, 2007