Q-Theory of Investment  

 

Nobel laureate economist James Tobin has proposed the q theory of investment which links a firm’s investment decisions to fluctuations in the stock market. When a firm finances its capital for investment by issuing shares in the stock market, its share prices reflect the investment decisions of the firm.

 

Firm’s investment decisions depend on the following ratio, called Tobin’s q:

 

q = Market Value of Capital Stock/Replacement Cost of Capital

 

The market value of firm’s capital stock in the numerator is the value of its capital as determined by the stock market. The replacement cost of firm’s capital in the denominator is the actual cost of existing capital stock if it is purchased at today’s price. Thus Tobin’s q theory explains net investment by relating the market value of firm’s financial assets (the market value of its shares) to the replacement cost of its real capital (shares).

 

According to Tobin, net investment would depend on whether q is greater than (q>1) or less than 1 (q<1). If q> 1, the market value of the firm’s shares in the stock market is more than the replacement cost of its real capital, machinery etc.

The firm can buy more capital and issue additional shares in the stock market. In this way, by selling new shares, the firm can earn profit and finance new investment. Conversely, if q<1, the market value of its shares is less than its replacement cost and the firm will not replace capital (machinery) as it wears out.

 

Let us explain it with the help of an example. Suppose a firm raises finance for investment by issuing 10 lakh shares in the stock market at Rs 10 per share. Currently, their market value is Rs 20 per share. If the replacement cost of the firm’s real capital is Rs 2 crores then the q ratio is 1.00 (= Rs 2 crores market value / Rs 2 crores replacement cost).

 

Suppose the market value rises to Rs 40 per share. Now the q ratio is 2 (=Rs 40/ Rs20). Now the market value of its shares gives Rs 2 crores (=Rs 4 crores-Rs 2 crores) as profit to the firm. The firm raises its capital stock by issuing 5 lakh additional shares at Rs 40 per share. Rs 2 crores collected through the sale of 5 lakh shares are utilised for financing new investment by the firm.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Panels (A) and (B) of Fig. 15 illustrate how an increase in Tobin’s q induces a rise in the firm’s new investment. It shows that an increase in the demand for shares raises their market value which raises the value of q and investment.

The demand for capital is shown by the demand curve D in Panel (A). The relative value of q is taken as unity, as the market value and replacement cost of capital stock are assumed equal. The initial equilibrium is determined by the interaction of demand for capital and the available supply of capital stock OK at point E, which is fixed in the short run.

The demand for capital depends mainly on two factors. First, the level of wealth of the people. The higher is the level of wealth, the more shares people wish to have in their wealth portfolio. Second, the real return on other assets such as government bonds or real estate.

 

A fall in the real interest rate on government bonds would induce people to invest in shares than in other forms of wealth. This would increase the demand for capital and raise the market value of capital above its replacement cost.

This means rise in the value of Tobin’s q above unity. This is shown as the rightward shift of the demand curve to D1. The new equilibrium is established at E1 in the long run when the replacement cost rises and equals the market value of capital. The rise in the value of q to q1 induces an increase in new investment to OI, as shown in Panel (B) of the figure.

 

Reference:

 Smriti Chand. New Theories of Investment. http://www.yourarticlelibrary.com/macro-economics/theories-macro-economics/7-new-theories-of-investment-are-explained-below/31082/