Journal of Financial Economics 130 (2018) 620–640 Contents lists available at ScienceDirect Journal of Financial Economics journal homepage: www.elsevier.com/locate/jfec R Investment, Tobin’s q , and interest rates ∗ Xiaoji Lin a, Chong Wang b, Neng Wang c,d, , Jinqiang Yang e a University of Minnesota, 321 19th Ave S, Minneapolis, MN 55455, United States b Graduate School of Business and Public Policy, Naval Postgraduate School, Monterey, CA 93943, United States c Columbia University, 3022 Broadway, Uris Hall 812, New York, NY 10027, United States d National Bureau of Economic Research, 1050 Massachusetts Ave., Cambridge, MA 02138, United States e School of Finance, Shanghai University of Finance and Economics, Guoding Rd. 777, Shanghai 200433, China a r t i c l e i n f o a b s t r a c t Article history: We study the impact of stochastic interest rates and capital illiquidity on investment and Received 29 September 2013 firm value by incorporating a widely used arbitrage-free term structure model of interest Revised 24 October 2016 rates into a standard q theoretic framework. Our generalized q model informs us to use Accepted 5 May 2017 corporate credit-risk information to predict investments when empirical measurement is- Available online 2 May 2018 sues of Tobin’s average q are significant (e.g., equity is much more likely to be mis-priced JEL classification: than debt), as in Philippon (2009). We find, consistent with our theory, that credit spreads G31 and bond q have significant predictive powers on micro-level and aggregate investments G12 corroborating the recent empirical work of Gilchrist and Zakrajšek (2012). We also show E2 that the quantitative effects of the stochastic interest rates and capital illiquidity on in- vestment, Tobin’s average q , the duration and user cost of capital, and the value of growth Keywords: opportunities are substantial. These findings are particularly important in today’s low in- Term structure of interest rates terest rate environment. Capital adjustment costs Assets in place © 2018 Elsevier B.V. All rights reserved. Growth opportunities Bond q 1. Introduction rates. Various macroeconomic models rely on this nega- tive relation. The neoclassical q theory of investment ex- A widely held conventional wisdom in macroeconomics plicitly incorporates productivity shocks and capital adjust- is that investment should respond negatively to interest ment costs into a dynamic optimizing framework and gen- erates predictions between investment and interest rates. 1 However, almost all q theoretic models assume that the R We thank Patrick Bolton, Simon Gilchrist, Steve Grenadier, Lars Hansen, Bob Hodrick, Thomas Philippon, Tom Sargent, Lukas Schmid, interest rate is constant over time, which by construction Bill Schwert (Editor), Suresh Sundaresan, and seminar participants at rules out the impact of the interest rate risk and dynamics Columbia, and the discussants of workshops hosted by the China Young on investments. Moreover, limited empirical evidence sup- Finance Scholars Society for helpful comments. We are very grateful to ports the widely used investment and interest rate relation the anonymous referee for invaluable comments which significantly im- 2 proved our paper. The work was completed while Xiaoji Lin was at the and the q theory of investment. Philippon (2009) demon- Ohio State University. Jinqiang Yang acknowledges the support from the National Natural Science Foundation of China (# 71522008 , # 71472117 , # 71772112 , # 71573033 , # 71532009 , and # 71532012 ), Innovative Research 1 Lucas and Prescott (1971) and Abel (1979) study investment dynamics Team of Shanghai University of Finance and Economics (# 2016110241 ), under uncertainty with convex adjustment costs. Hayashi (1982) provides and Fok Ying-Tong Education Foundation of China (#151086). homogeneity conditions under which the firm’s marginal q is equal to its ∗ Corresponding author. average q . E-mail addresses: [email protected] (X. Lin), [email protected] (C. Wang), 2 Abel and Blanchard (1986) show that marginal q , constructed as the [email protected] (N. Wang), [email protected] (J. expected present value of marginal profits, still leaves unexplained large Yang). and serially correlated residuals in the investment regressions. https://doi.org/10.1016/j.jfineco.2017.05.013 0304-405X/© 2018 Elsevier B.V. All rights reserved. X. Lin et al. / Journal of Financial Economics 130 (2018) 620–640 621 strates that interest rates measured by bond yields have to avoid standard investment opportunity measures, e.g., significant predictive power for aggregate investment even Tobin’s q , which often have significant measurement is- in the Modigliani–Miller (MM) world. He argues that the sues. The premise of our analysis that Tobin’s q can be superior performance of bond prices over standard total poorly measured is well recognized in the investment lit- firm value–based measures (e.g., Tobin’s average q ) for in- erature. Erickson and Whited (20 0 0) show that a stan- vestment regressions can be plausibly attributed to mis- dard neoclassic q theory without any financial imperfec- pricing, in that equity being the levered claim on the firm tion, despite its simple structure, has good explanatory is more likely to be mis-priced than bonds making bond power once empirical measurement error issues are prop- prices more informative for investment or a potential dis- erly addressed, e.g., via method of moments. 6 connect (even in a rational model) between current capital We find, consistent with our theory, that the relative investments and future growth options. 3 bond prices positively and credit spreads negatively pre- In terms of the theory, we recognize the importance dict investment at both the firm and the aggregate level. of stochastic interest rates on investment and the value Moreover, the predictive power of credit risk–based mea- of capital by incorporating a widely used term structure sures for investment remains strong and robust after con- model of interest rates ( Cox et al., 1985 ) into a neoclassi- trolling for well-known predictors. Our empirical findings cal q theoretic model of investment ( Hayashi, 1982 ). 4 We are consistent with recent work. For example, Gilchrist show that investment decreases with interest rates and, et al. (2007) report that increasing the user cost of cap- moreover, that the term structure of interest rates has first- ital by 100 basis points is associated with a reduction order and highly nonlinear effects on investment and To- of investment around 50–75 basis points and a 1% re- bin’s average q . Therefore, a firm ignoring the interest rate duction in the capital stock in the long run. Philippon risk and dynamics significantly distorts its investment and (2009) shows that aggregate corporate bond yields predict reduces its value. Furthermore, in a low interest rate en- aggregate investment substantially better than the stock vironment such as today’s, capital illiquidity, measured by market–based measures, e.g., Tobin’s q . Gilchrist and Za- the capital adjustment costs as in the standard q theory, krajšek (2012) show that their constructed corporate bond has very large effects on corporate investment, Tobin’s q , yield index has considerable predictive power for aggregate the user cost of capital, and the value of growth oppor- economic variables. In summary, our aggregate and firm- tunities. Given the wide range of parameter estimates in level results corroborate these existing studies and provide the literature for capital adjustment costs, which is of- additional support for the q theory of investment. ten premised on the constant interest rate assumption, our The remainder of the paper proceeds as follows. analysis highlights the importance of explicitly incorporat- Section 2 presents our q theory of investment with term ing risk-adjusted interest rate dynamics via an arbitrage- structure of interest rates. In Section 3 , we solve the model free term structure and reestimating capital illiquidity and and discuss its quantitative results. Section 4 provides the adjustment cost parameters. 5 As physical capital is long empirical evidence for the model’s predictions for both the lived subject to depreciation, the duration, Tobin’s q , and firm level and the aggregate data. Section 5 concludes. Ap- value of the firm’s growth opportunities are all sensitive to pendices contain technical details related to the main re- capital adjustment costs, especially when interest rates are sults in the paper and also a few generalizations of our low. baseline model. We further generalize our q theory with stochas- tic interest rates to incorporate leverage by building on 2. Model Philippon (2009) . This generalization is important for our empirical analyses because it motivates us to use credit We generalize the neoclassic q theory of investment to risk information to predict corporate investment and also incorporate the effects of stochastic interest rates and then introduce leverage in an MM setting with the objective of linking our model’s prediction to bond data as in Philippon 3 Gilchrist et al. (2005) show that dispersion in investor beliefs and (2009) . short-selling constraints can give rise to mis-pricing in the stock market and a weak link between investment and the market. A disconnect exam- 2.1. Economic environment ple is that when growth options differ significantly from existing opera- tions and near-term investment decisions are primarily driven by physical capital accumulation, bond prices are naturally more informative for in- First, we introduce our model setup. vestments than the firm’s total value, as the equity value portion of the firm’s value is mostly determined by the perceived value of growth op- tions, which is largely uncorrelated with the value of capital stock. 2.1.1. Stochastic interest rates 4 Abel and Eberly (1994) develop a unified neoclassical q theory of in- While much work in the q theory context assumes con- vestment with constant interest rates. McDonald and Siegel (1986) and stant interest rates, empirically, interest rates vary sub- Dixit and Pindyck (1994) develop the real options approach of investment stantially over time.