What do frictions mean for Q-theory testing?

Maria Cecilia Bustamante
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Maria Cecilia Bustamante: University of Lausanne and Swiss Finance Institute

No 08-47, Swiss Finance Institute Research Paper Series from Swiss Finance Institute

Abstract: This paper develops and empirically tests a model designed to distinguish the role of real and financing frictions on firms investment, debt financing and equity financing policies. Real frictions include fixed costs of investment and adjustment costs. Financing frictions include taxes, collateral constraints, flotation costs of equity and dividend constraints. Because of financing frictions, all corporate policies are interrelated and depend on average Q. Due to fixed costs of investment and binding financing constraints,the sensitivity of corporate policies to Q is non-linear. The empirical tests demonstrate that both the endogeneity and non-linearities created by real and financing frictions are economically significant. The paper provides a rationale for the documented poor performance of Q-theory in explaining investment, and for the differential performance of the neoclassical investment model in explaining investment and stock returns. The paper extends Q-theory to explain debt and equity issues, and shows that market to book sorts control for non-linearities in investment policies.

Keywords: Tobin's Q; financing frictions; fixed costs. (search for similar items in EconPapers)
JEL-codes: E22 G11 G32 (search for similar items in EconPapers)
Pages: 50 pages
Date: 2008-11
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