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.
Monday, June 2, 2008
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.
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.’
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).
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.
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.
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