18-10-2023

Investment
Tobin’s Q theory of investment
Errol D’Souza
Tobin’s model of investment focuses on asset prices as the
basis for investment spending

𝑀𝑎𝑟𝑘𝑒𝑡 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐹𝑖𝑟𝑚

𝑄=
𝑅𝑒𝑝𝑙𝑎𝑐𝑒𝑚𝑒𝑛𝑡 𝐶𝑜𝑠𝑡 𝑜𝑓 𝐼𝑛𝑠𝑡𝑎𝑙𝑙𝑒𝑑 𝐶𝑎𝑝𝑖𝑡𝑎𝑙

When 𝑄 is greater than 1, the stock market is signalling that

the value of the firm is greater than its capital stock
Indian Institute of
Advanced Study and the firm should invest more in capital.
Rashtrapati Niwas
Shimla
Purchasing new capital increases the value of the firm
Turin School since the market value of capital is greater than
of Development
the cost of acquiring it

Email: errol@iimahd.ernet.in

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Market value of a firm is the price of its shares multiplied

𝐷2 : dividend in the next period
by the number of shares outstanding
𝑃2𝑆 − 𝑃1𝑆 : the capital gain/loss
Consider an investor who has a sum of money to invest:
Then, 𝑟𝑃1𝑆 = 𝐷2 + 𝑃2𝑆 − 𝑃1𝑆
Money could be put into a deposit account that pays
out an interest rate of 𝑟.
Dividing throughout by 𝑃1𝑆 ,
Alternatively, the investor can purchase a stock at
𝐷2 𝑃2𝑆 −𝑃1𝑆
the current price of 𝑃1𝑆 , hold the share for a 𝑟= +
𝑃1𝑆 𝑃1𝑆
year, and then sell it.
𝐷2 +𝑃2𝑆
At the end of the year the investor would or, 𝑟= −1
𝑃1𝑆
receive
─ a dividend, and
𝐷2 +𝑃2𝑆
or, 𝑃1𝑆 =
1+𝑟
─ a capital gain or loss

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𝐷2 𝐷3 𝐷4 𝐷5
𝑃1𝑆 = + + + +⋯
𝐷2 + 𝑃2𝑆 1+𝑟 1+𝑟 2 1+𝑟 3 1+𝑟 4
𝑃1𝑆 =
1+𝑟
If we take the case where the firm pays the same dividend over
𝑆
In general, 𝑃𝑡𝑆 = 𝐷𝑡+1 + 𝑃𝑡+1 Τ 1 + 𝑟 allowing us to write
time, i.e., 𝐷2 = 𝐷3 = 𝐷4 = ⋯, then, the geometric series results
the above expression as
in the expression
𝐷2 𝑃2𝑆 𝐷2 𝐷3 +𝑃3𝑆 ൗ 1+𝑟 𝐷2
𝑃1𝑆 = 1+𝑟
+ 1+𝑟
= 1+𝑟
+ 1+𝑟 𝑃1𝑆 =
𝑟

𝐷2 𝐷3 𝑃3𝑆 Now consider the IRR or the internal rate of return of an

or, 𝑃1𝑆 = + +
1+𝑟 1+𝑟 2 1+𝑟 2
investment in capital. The internal rate of return is
Extrapolating, the current price of a share is given by the interest rate at which the net present value of
𝐷2 𝐷3 𝐷4 𝐷5
the future returns from the investment is equal to
𝑃1𝑆 = + + + +⋯
1+𝑟 1+𝑟 2 1+𝑟 3 1+𝑟 4 the cost of the investment.

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∞
𝐷2 𝐷3 𝐷4 𝐷5 𝐷𝑡+1
We focus on the returns to shareholders or equity internal + 2
+ 3
+ 4
+⋯=෍ 𝑡
1 + 𝑟𝑁 1 + 𝑟𝑁 1 + 𝑟𝑁 1 + 𝑟𝑁 1 + 𝑟𝑁
rate of return. This is not the same as the IRR of the 𝑡=1

capital investment project if the project is financed The value of 𝑟𝑁 is calculated from the formula that the above
by a mix of debt and equity. net present value of the returns to a shareholder is
equal to the costs incurred in undertaking the invest-
The shareholders are concerned solely with the returns to ment which is none other than the replacement cost
them and not with the returns to the project and so of the firm’s installed capital
the cash flow they focus on is the dividend that they
∞
receive after the debt has been serviced. 𝐷𝑡+1
෍ 𝑡
− 𝑅𝑒𝑝𝑙𝑎𝑐𝑒𝑚𝑒𝑛𝑡 𝐶𝑜𝑠𝑡 𝑜𝑓 𝐼𝑛𝑠𝑡𝑎𝑙𝑙𝑒𝑑 𝐶𝑎𝑝𝑎𝑐𝑖𝑡𝑦 = 0
1 + 𝑟𝑁
𝑡=1
The net present value of the future returns from the
investment in capital for a shareholder then is given we can write,
by
𝐷2 𝐷3
Replacement Cost of Installed Capacity = +
1+𝑟𝑁 1+𝑟𝑁 2
𝐷2 𝐷3 𝐷4 𝐷5 𝐷𝑡+1
+ + + + ⋯ = σ∞
𝑡=1
1+𝑟𝑁 1+𝑟𝑁 2 1+𝑟𝑁 3 1+𝑟𝑁 4 1+𝑟𝑁 𝑡
𝐷4 𝐷5 𝐷𝑡+1
+ + + ⋯ = σ∞
𝑡=1
1+𝑟𝑁 3 1+𝑟𝑁 4 1+𝑟𝑁 𝑡
where 𝑟𝑁 is the internal rate of return

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𝐷2 𝐷3
𝑅𝑒𝑝𝑙𝑎𝑐𝑒𝑚𝑒𝑛𝑡 𝐶𝑜𝑠𝑡 𝑜𝑓 𝐼𝑛𝑠𝑡𝑎𝑙𝑙𝑒𝑑 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 = + 2
1 + 𝑟𝑁 1 + 𝑟𝑁
+
𝐷4
+
𝐷5 ∞
+ ⋯ = σ𝑡=1
𝐷𝑡+1 An alternative way of thinking about Tobin’s Q then is that
1+𝑟𝑁 3 1+𝑟𝑁 4 1+𝑟𝑁 𝑡
it is the ratio of the internal rate of return, 𝑟𝑁 , to the
opportunity cost of the funds used to install the cap-
ital, 𝑟.
For the case where 𝐷2 = 𝐷3 = 𝐷4 = ⋯,

𝐷 When Q is greater than 1 the profitability of the invest-

𝑅𝑒𝑝𝑙𝑎𝑐𝑒𝑚𝑒𝑛𝑡 𝐶𝑜𝑠𝑡 𝑜𝑓 𝐼𝑛𝑠𝑡𝑎𝑙𝑙𝑒𝑑 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 = 𝑟 2 ment in capital as measured by 𝑟𝑁 is greater than the
𝑁
cost of installing capital as measured by 𝑟 and the firm
Tobin’s Q then is given by should invest in more capital.

𝑀𝑎𝑟𝑘𝑒𝑡 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐹𝑖𝑟𝑚
𝑄 = 𝑅𝑒𝑝𝑙𝑎𝑐𝑒𝑚𝑒𝑛𝑡 𝐶𝑜𝑠𝑡 𝑜𝑓 𝐼𝑛𝑠𝑡𝑎𝑙𝑙𝑒𝑑 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 = 𝐷 2Τ𝑟 =
𝐷 Τ𝑟 𝑟𝑁 Since the replacement cost of capital is correlated with the
2 𝑁 𝑟 overall price level of the economy which is not as
volatile as stock prices it is changes in the market
value of firms as reflected in stock prices that sub-
stantially change Tobin’s Q and investment.

When the stock market values escalate so does investment

and when they plummet so does investment

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Π𝑡 : denotes profit per unit of capital

This approach is not different from the one that states that
a firm should invest in capital till the value of the
Y𝑡 ∶ sales which we take to be equal to output for simplicity
additional output the capital produces, 𝑃𝑡 𝑀𝑃𝐾 , equals
the user cost
K 𝑡 ∶ capital stock at time 𝑡
User cost of capital is what it costs to install capital or the
replacement cost of capital Then, Π𝑡 is an increasing function of 𝑌𝑡 Τ𝐾𝑡

𝑌𝑡 Τ𝐾𝑡 is directly related to the marginal productivity of

The market value of stock reflects the future dividends as
we saw and that in turn corresponds to the expected
profit from capital.
The profit from a unit of capital will increase with the
ratio of sales or output to the capital stock.
capital. For instance, suppose that output is prod-
uced by a Cobb-Douglas production function. Then,
the marginal productivity of capital is proportional
to 𝑌𝑡 Τ𝐾𝑡
∴ market value of firms depends on …. future stream of div-
idends which …. is related to the profits of the firm.
Profits is related to 𝑌𝑡 Τ𝐾𝑡 , which ….is again in turn
related to marginal productivity

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Hence, the same factors that were earlier listed as deter-
minants of investment behaviour continue to have
relevance when Tobin’s Q is being considered
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18-10-2023
What Tobin’s Q adds to our previous understanding of the
determinants of investment is that asset price fluct-
uations as displayed in the stock market have an
independent and significant effect on investment exp-
enditure.
Stock markets are leading business indicators and a
decline in the stock market is an important factor
contributing to the decline in output and exp-
enditure in the economy.
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Errol D’Souza
Investment in Developing Countries -
Equity markets are typically small and underdeveloped
and the prevalence of financial repression
implies that Tobin’s Q must be applied
cautiously
Cost of funds in informal markets has been found to
influence private investment when the firms
are credit rationed in the formal financial sector
Foreign exchange rationing and the cost of foreign
exchange in unofficial curb markets can be
important determinants of private investment
in many developing countries with fledgling
capital-goods sectors that resort to imports of
capital goods
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Errol D’Souza
Existence of a debt overhang, which indicates the
possibility of future taxation that will be used
to finance future debt service, has been found
to inhibit private investment
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Errol D’Souza
Uncertainty has been found to adversely impact on
private investment
Political uncertainty — government instability,
rapid government turnover, and social unrest —
vary negatively with investment
Volatility of output growth is an indicator of the
unpredictability of demand and the volatility of
inflation is an indicator of macroeconomic
uncertainty
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18-10-2023
Errol D’Souza
Existence of a debt overhang, which indicates the
possibility of future taxation that will be used
to finance future debt service, has been found
to inhibit private investment
Complementarity- substitutability relationships
between public and private investment
Public-sector investment can crowd out private
Investment expenditure if it uses scarce phys-
ical and financial resources that would other-
wise be available to the private sector
Public investment that expands infrastructure
and the provision of public goods can raise the
productivity of private capital and is complem-
entary to private investment
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Errol D’Souza
Corruption tends to increase the number of projects
undertaken and expand their size. Thus whilst
increasing the share of public investment to
GDP, corruption also lowers the quality of
public investment put in place
It has been found that higher corruption for a
given level of public investment is associated
with lower quality of public investment, which
tends to lower private investment
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Errol D’Souza Errol D’Souza

Investment in India Because the credibility and sustainability of reforms

Include the availability of finance—measured in terms
of real bank credit to the private sector, BC—as
a determinant of investment
Public-sector fixed capital formation can affect
investment from the supply side through
infrastructure investments, or the demand
side through competing for investible funds
I public
Cost of capital (CC) = p K ( r +  )
GDP (Y)
Capital stock in the private sector (K )
could affect the perception of firms about
investment opportunities, a post-reform
intercept dummy (PRD), which takes the value
of one for the post-reform years and zero
otherwise
Private investment in India is then given by -
I t = −1.28 + 0.13BCt −1 + 2.98Yt − 3.89CC t + 0.68I public + 1.06 I public, t −1
− 0.50 K t −1 − 0.45I t −1 + 0.75PRD

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Errol D’Souza

Business investment in any given year accelerates

with changes in GDP and there is a positive
effect of bank credit (BC)

Public investment has a strong complementary

effect on business investment in India

Cost of capital (CC) and the initial capital stock K t −1

have negative effects on investment

The positive coefficient on the post-reform dummy

(PRD) indicates that the reforms have had an
investment enhancing impact

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