Review of Quantitative Finance and Accounting, 12 (1999): 35–47
© 1999 Kluwer Academic Publishers, Boston. Manufactured in The Netherlands.
Q, Cash Flow and Investment: An Econometric
CHRISTOPHER F. BAUM
Boston College, Chestnut Hill, MA 02467; firstname.lastname@example.org
CLIFFORD F. THIES
Shenandoah University, 1460 University Drive, Winchester, VA 22601; email@example.com.
Abstract. The effects of measurement and speciﬁcation error on estimates of the Q and cash ﬂow model of
investment are investigated. Two sources of error are considered: expensing of R&D expenditures and failing to
identify that component of cash ﬂow which relaxes ﬁnancing constraints. We apply random-effects and instru-
mental variables estimators to a model that addresses these sources of error. We ﬁnd that: (1) the capitalization
of R&D strengthens the explanatory power of the model; (2) expected and unexpected components of cash ﬂow
have different effects; and (3) the effects of Q are much more evident in ﬁrms facing low costs of external
Key words: Tobin’s Q, Investment
The Q model of investment, for all of its analytical appeal, has achieved only modest
success in empirical research. Tobin’s Q, deﬁned as the ratio of the market value of the
ﬁrm to the replacement cost (or current cost) value of its assets, can be shown to be a
“sufﬁcient statistic” for investment (Chirinko 1995). Yet, beginning with the work of
Fazzari, Hubbard and Petersen (1988), and continuing through a growing and now inter-
national body of empirical research (UK: Devereux and Schiantarelli (1990), Japan:
Hoshi, Kashyap and Scharfstein (1991), Germany: Elston (1993), and Canada: Schaller
(1993)), Q has made only a small contribution to the explanatory power of investment
spending equations that also include cash ﬂow or some other output-related variable.
The dogged search for the role played by Q in investment decisions is understandable.
The Q model of investment, in addition to being soundly grounded in theory, identiﬁes an
explicit linkage between the real and ﬁnancial sectors of the economy. Furthermore,
certain empirical regularities appear to be consistent with the Q model: its performance
appears to be stronger in subsamples consisting of ﬁrms that can be presumed not subject
to liquidity constraints than it does in subsamples of apparently liquidity-constrained
ﬁrms. This interplay of Q and investment with capital market imperfections is itself
intriguing, and has led to a sizable literature (for a recent summary, see Schiantarelli,
1995, pp. 180–185).
@ats-ss5/data11/kluwer/journals/requ/v12n1art3 COMPOSED: 09/21/98 11:51 am. PG.POS. 1 SESSION: 5