A model of investment with financial constraints is used to study the relation between investment and Tobin’s q. A firm is financed by both inside and outside investors. When insiders’ wealth is scarce, the firm’s value includes a quasi-rent on invested capital. Therefore, two forces drive q: the value of invested capital and future quasi-rents. Relative to a frictionless benchmark, this weakens the relationship between investment and q, generating more realistic correlations between investment, q, and cash flow. The quantitative implications of the model for investment regressions depend crucially on the nature of the shocks hitting the firm.

Introduction

Dynamic models of the firm imply that investment decisions and the value of the firm should both respond to expectations about future profitability of capital. In models with constant returns to scale and convex adjustment costs these relations are especially clean, as investment and the firm’s value respond exactly in the same way to new information about future profitability. This is the main prediction of Tobin’s q theory, which implies that current investment moves one-for-one with q, the ratio of the firm’s financial market value to its capital stock. This prediction, however, is typically rejected in the data, where investment appears to correlate more strongly with current cash flow than with q. In this paper, we investigate the relation between investment, q, and cash flow in a model with financial frictions. The presence of financial frictions introduces quasi-rents in the market valuation of the firm. These quasi-rents break the one-to-one link between investment and q. We study how the presence of these quasi-rents affects the statistical correlations between investment, q, and cash flow, and ask whether a model with financial frictions can match the correlations in the data. Our main conclusion is that the presence of financial frictions can bring the model closer to the data, but that the model’s implications depend crucially on the shock structure. In a model with financial frictions it is still true that investment and q respond to future profitability, but the two variables now respond differently to information at different horizons. Investment is particularly sensitive to current profitability, which determines current internal financing, and to near-term financial profitability, which determines collateral values. On the other hand, q is relatively more sensitive to profitability farther in the future, which will determine future growth and thus the size of future quasi-rents. Therefore, to break the link between investment and q, requires the presence of both shortlived shocks—which tend to move investment more and have relatively smaller effects on q—and long-lived shocks—which do the opposite. These points are developed in the context of a stochastic model of investment sub ject to limited enforcement, with fully state-contingent claims. The ability of borrowers to issue state-contingent claims is limited by the fact that, ex post, they can renege on their promises and default. The consequence of default is the loss of a fraction of in vested assets. We show that this environment is equivalent to an environment with state contingent collateral constraints, so the model is essentially a stochastic version of Kiyotaki and Moore (1997) with adjustment costs and state-contingent claims.