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Q Theory Without Adjustment Costs & Cash Flow Effects Without Financing Constraints

Janice Eberly () and Andrew Abel ()

No 205, 2004 Meeting Papers from Society for Economic Dynamics

Abstract: Tobin's Q exceeds one, even without any adjustment costs, for a firm that earns rents as a result of monopoly power or of decreasing returns to scale in production. Even when there are no adjustment costs and marginal Q is always equal to one, Tobin's Q is informative about the firm's growth prospects. We show that investment is positively related to Tobin's Q (which is observable average Q). This effect can be quantitatively small, which has been taken as evidence of very high adjustment costs in the empirical literature, but here is consistent with no adjustment costs at all. In addition, cash flow has a positive effect on investment, and this effect is larger for smaller, faster growing and more volatile firms, even though capital markets are perfect. These results provide a new theoretical foundation for Q theory and also cast doubt on evidence of financing constraints based on cash flow effects on investment

Keywords: Q Theory; Cash Flow; Investment (search for similar items in EconPapers)
JEL-codes: E22 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-acc, nep-ent and nep-mac
Date: 2004
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