Tobin q empirical evidence

Empirical Evidence:

Researchers have found that investment in new capital goods do
tend to rise when the stock market rises and fall when the market
falls although the relationship is not always strong. Reason being
that stock prices reflect many assets besides capital, such as patents
a firm holds or the reputation of a firm’s products. Thus changes in
stock prices are imperfect measures of the changes in the market
value of capital.

Tobin's q ratio is in fact similar to the neoclassical theory. We saw
3 factors affected the desired capital stock – the expected future
marginal product of capital MPk; the real interest rate, r; and the
purchase price of new capital, Pk. Each of these factors also affect
Tobin’s q. An increase in the MPk increase in expected future
earnings of the firm and this raises the stock market value of the
firm and thus q. A reduction in r also tend to increase stock prices
as financial investors substitute away from low-yielding bonds and
bank deposits and buy stocks instead. A decrease in the purchase
price of capital reduces the denominator of the q ratio and thus
increases q.

Tobin q basic idea

Basic Idea:

Rate of investment in any type of capital can be predicted
by looking at the ratio of the capital’s market value to the
replacement cost of its capital stock.
When the ratio of capital market value to its replacement
Notescost (Tobin’s q) is > 1, it is profitable for the firm to acquire
additional capital because the value of capital exceeds the
cost of acquiring it; and vice versa. Investment is therefore a
positive function of the q ratio.

Since much of the value of firms come from the capital they
own, the stock market value of a firm can be used as a
measure of the market value of the firm’s capital stock.

If the replacement cost of capital isn’t changing much
then a boom in the stock market (an increase in V) will
cause Tobin’s q to rise for most firms increase in the
rates of investment. Simply put, when the stock market is
high, firms find it profitable to expand.

Tobin’s q ratio

Tobin’s q ratio

The desired capital stock can be determined in other ways.
Economic theory suggests that rises and falls in the stock market
does lead firms to change their rates of capital investment in the
same direction. This relationship between stock prices and firm’s
investment in physical capital is captured by Tobin’s ‘q theory of
investment.’

Related Decision Rules

Related Decision Rules

Present Value Rule
Most capital goods last longer than a year, therefore
the investment decision must be based on an expected
stream of income over time. Future returns must be
discounted to arrive at their present value which is then
used to evaluate the potential for investment.

Firms should know the net present value (NPV) when
deciding whether to buy a capital equipment or not.
NPV is simply the present value of the capital good
less the supply price of capital (Sk). Sk is the price the
firm has to pay to acquire the capital good. Hence, if
NPV >0, indicating that the PV of the project is greater
than the supply price, the firm can gain by investing in
the project; and vice versa.

Profits, Liquid Assets and Investments

Profits, Liquid Assets and Investments
Profits

Studies have indicated that a positive relationship exists
between net investment and a firm’s profit or cash flow.
Cash flows tend to have a bigger effect on the investment of
firms which are more likely to face financial constraints. As
early as 1957, it was found that firm’s seeming preference
for internal funds. Cash flow can affect investment as
capital markets are imperfect and internal finance is
cheaper than external finance. Therefore one would
expect cash flow to play a stronger role on investment of
firms likely to face financial constraints.

Liquid Assets
Some studies also suggest that net investment is
positively related to a firm’s liquid assets. The causality
is however unclear as to whether it is liquid assets that
affect investment or whether expected future investment
could cause liquid assets to be accumulated (i.e. causality
from investment to liquid assets rather than the other way
round).

Simple accelerator model 2

The simple accelerator model assumes that the desired
level of capital stock is a fixed ratio to output. But there
are reasons to expect this ratio is not constant but varies
depending upon the cost of capital to labour, interest
rates and tax rates etc.

The simple accelerator model assumes that firms can
instantaneously adjust their capital stock to the observes
level of demand. This is expecting too much.” Time to
build” can be significant.

The Simple Accelerator Model of Investment

The Simple Accelerator Model of Investment

The simple accelerator model – states that for each period the
optimum capital stock (K) is positively related to the level
of output in that period by a fixed capital-output ratio.

The accelerator model specifies that the desired stock of capital is
a multiple of the output level.
In its simplest form, net investment is equal to the difference
between the desired capital stock and the stock of capital
inherited from the preceding period. The stock of capital inherited from the last period is the desired capital stock based on the output in the last period.

Investment spending depends on the rate of change in output.
Hence, when business is good and expected output increases, net
investment is positive and vice versa.

Concept:

Concept:
The concept is based on the ordinary mathematical technique of
computing present value of a given series of returns discounted at
a specified discount rate.

Let’s take an example of a short-lived project (5 years). Let R1,
R2….R5 represent the expected stream of returns of this particular
investment project. As the returns are in the future, their values
have to be discounted to the present in order to get their present
value.

Let Sp be the cost of undertaking the project – i.e. the replacement
cost of capital or "supply price" of capital goods.
The internal rate of return (or marginal efficiency of investment)
would be the discount rate , which will equate the expected yield
with the supply price of capital.

Main conclusions:

Main conclusions:

Firm’s demand for the desired capital stock (k*) depends on
the rental cost (rc) and the expected level of output (Y);
The lower rc, the higher the level of K relative to output.
The higher the expected level of output, the larger the
desired capital stock.

An alternative approach to business investment decision is
the discounted cash flow analysis. In considering whether to build a
factory for example, a firm will have to work out how much it costs
to build the factory and the revenue it will bring about in each year
after it starts operation.

MEC (internal rate of return) is the rate of discount that would
make the present value of expected income from fixed capital
assets equal to the present supply price of the asset. The
level of investment is determined by the MEC relative to the rate
of interest. If MEC > r, investment will be stimulated; if not,
investment will be discouraged.

Changes in the desired capital stock

MPk is downward sloping for different sizes of capital stock (K)
as the marginal product of capital falls as the capital stock
increases (diminishing marginal productivity of capital. If rental
cost is rco, the amount of capital that maximizes the expected profit
is K*.

Changes in the desired capital stock
Any factor that shifts the MPk curve or changes the rental cost
changes the firms desired capital stock. A fall in rental cost
shifts the rc line down . At the original desired capital stock, MPk
is now greater than the user cost. The firm will be able to increase
increase profit by raising its desired capital stock. Technological changes
affects the MPk i.e. shifts the MPk curve and therefore also affects
the desired capital stock. Advancement in technology increases
the MPk, shifting the MPk to the right (upward) resulting in an
increase in desired capital stock for the same resource cost. How
will an increase in output affect the MPk?

Theories of Investment 2

Firms can determine the profit maximizing level of capital
stock by comparing the costs and benefits of using additional
capital. If the benefits outweigh the costs, the firm will raise its
profit by expanding its capital stock. If the costs outweigh the
benefits, the firm should not increase its planned capital stock.
The marginal product of capital (MPk) is the benefit from having
an additional unit of capital. MPk is the additional output a firm
can obtain by adding a unit of capital, all other things constant.

The cost of using capital (rental cost, rc), on the other hand, is
equal to the real interest rate times the price of the capital and
the rate at which capital depreciates.
rc = r.Pk + d

A firm’s desired capital stock is the capital stock at which the
marginal product of capital equals the rental cost of capital.

Theories of investment

Theories of investment

The two theories of investment we will be looking at are the
Neoclassical model and the accelerator model. Thereafter we
will proceed to look at other factors that might affect
investment.

The Neoclassical model of Investment
The Neoclassical model basically states that the desired capital
stock depends on two factors, namely the rental cost of capital
and the level of output.
K* = f (rc, Y)

Firms use both capital and labour to produce its output of
goods and services. Given that the objective of the firm is to
maximize profit, how then does the firm decide on the desired
capital stock?

Investment 1

Background

Investment is the most volatile component of GDP. In fact
most business cycles can be traced to fluctuations in investment.
Investment spending also determines the rate at which the
economy adds to its capital stock, which is important in
determining the economy’s long term growth and productivity
performance. In view of this, it is therefore important that we
understand what affects investment.

Investment is spending devoted to increase or maintain the
stock of capital. There are three major categories of
investment, namely (i) business fixed investment (business
spending on equipment and structures for use in production);

(ii) residential investment (purchase of new housing units); and
(iii) inventory investment (the value of changes in inventories of
finished goods, materials, supplies and work in progress).

In examining the determinants of investment, we will focus
mainly on business fixed investment and look at two issues:
How does a firm decide on the desired capital stock (k*)
to have (this is the capital stock the firm would like to
have in the long run)? and
What is the rate at which firms adjust from the existing
capital stock to the desired capital stock? The rate at
which the firm adjusts determines the rate of investment.

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