How Q and Cash Flow Affects Investment without Frictions: An Analytic Explaination

Tobin's Q exceeds one, even without any adjustment costs, for a firm that earns rents from monopoly power. Even when there are no adjustment costs and marginal Q is always equal to one, Tobin's Q is informative about the firm's growth prospects. We show that investment is positively related to Tobin's Q (which is observable average Q). In addition, cash flow has a positive effect on investment, and this effect is larger for smaller, faster growing and more volatile firms, even though capital markets are perfect. These results provide a new theoretical foundation for Q theory and also cast doubt on evidence of financing constraints based on cash flow effects on investment.