A unified theory of Tobins q,

corporate investment, financing,

and risk management
Patrick Bolton, Columbia, CEPR, and NBER
Hui Chen, MIT
Neng Wang, Columbia and NBER
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The Economist, Nov. 22-28, 2008
Model Design

constant investment opportunity (with a benchmark q

theory)

constant nancing opportunity

the interaction
Model Sketch: Physical
Production

capital accumulation:
dK
t
= (I
t
K
t
)dt

output:
dY
t
= K
t
(dt + dZ
t
)

cost of investing:
(I
t
+ G(I
t
, K
t
)) dt.

adjustment cost G(I, K) = g(I/K)K, where

g(i) =

2
i
2
.
Model Sketch

Dynamics for cash W: dW

t
= change in cash =

CF from operations (production)

+ CF from investing (i.e. (r ) W

t
dt)

+ CF from nancing

payout

Precautionary motive for holding cash

Cost of holding cash:

Can pay out cash to investors at any time: 1 for 1

Model Sketch

Dynamics for cash W: dW

t
= change in cash =

CF from operations (production)

+ CF from investing (i.e. (r ) W

t
dt)

+ CF from nancing

payout

Precautionary motive for holding cash

Cost of holding cash:

Can pay out cash to investors at any time: 1 for 1

Model Sketch

Dynamics for cash W: dW

t
= change in cash =

CF from operations (production)

+ CF from investing (i.e. (r ) W

t
dt)

+ CF from nancing

payout

Precautionary motive for holding cash

Cost of holding cash:

Can pay out cash to investors at any time: 1 for 1

Model Sketch

Dynamics for cash W: dW

t
= change in cash =

CF from operations (production)

+ CF from investing (i.e. (r ) W

t
dt)

+ CF from nancing

payout

Precautionary motive for holding cash

Cost of holding cash:

Can pay out cash to investors at any time: 1 for 1

Model Sketch

Dynamics for cash W: dW

t
= change in cash =

CF from operations (production)

+ CF from investing (i.e. (r ) W

t
dt)

+ CF from nancing

payout

Precautionary motive for holding cash

Cost of holding cash:

Can pay out cash to investors at any time: 1 for 1

Model Sketch

Dynamics for cash W: dW

t
= change in cash =

CF from operations (production)

+ CF from investing (i.e. (r ) W

t
dt)

+ CF from nancing

payout

Precautionary motive for holding cash

Cost of holding cash:

Can pay out cash to investors at any time: 1 for 1

Model Sketch

Dynamics for cash W: dW

t
= change in cash =

CF from operations (production)

+ CF from investing (i.e. (r ) W

t
dt)

+ CF from nancing

payout

Precautionary motive for holding cash

Cost of holding cash:

Can pay out cash to investors at any time: 1 for 1

Model Sketch

Option to liquidate

collect lK from capital and W from cash account

Option to issue external equity

xed cost

variable cost

Credit line

credit limit: cK

interest rate: r +
Model Sketch

Option to liquidate

collect lK from capital and W from cash account

Option to issue external equity

xed cost

variable cost

Credit line

credit limit: cK

interest rate: r +
Model Sketch

Option to liquidate

collect lK from capital and W from cash account

Option to issue external equity

xed cost

variable cost

Credit line

credit limit: cK

interest rate: r +
Four (optimally divided) regions

payout region

cash region (w > 0)

credit region (w < 0)

equity nancing (liquidation) region

Solution sketch

Firm value maximization: P(K, W)

Homogeneity: P(K, W) = p(w) K where w = W/K

Economics: stochastic balanced capital accumulation

with nancial frictions
Solution sketch

Firm value maximization: P(K, W)

Homogeneity: P(K, W) = p(w) K where w = W/K

Economics: stochastic balanced capital accumulation

with nancial frictions
Solution sketch

Firm value maximization: P(K, W)

Homogeneity: P(K, W) = p(w) K where w = W/K

Economics: stochastic balanced capital accumulation

with nancial frictions
Solution Sketch

Investment rst-order condition:

marginal cost of production =
P
K
(K, W)
P
W
(K, W)

marginal value of liquidity (marginal cost of funds):

P
W
(K, W) = p

(w)
Value and Investment

rm value-capital ratio p(w):

rp(w) = (i(w) ) (p (w) wp

(w))
+((r )w + i(w) g(i(w))) p

(w)
+

2
2
p

(w) .

investment-capital ratio:
i(w) =
1

p(w)
p

(w)
w 1

.
Average and marginal q

Optimal composition of the balance sheet: W and K

Average q:
q
a
(w) =
P(K, W) W
K
= p(w) w

Marginal q:
q
m
(w) =
dP(K, W)
dK
= q
a
(w) (p

(w) 1) w
Average and marginal q

Optimal composition of the balance sheet: W and K

Average q:
q
a
(w) =
P(K, W) W
K
= p(w) w

Marginal q:
q
m
(w) =
dP(K, W)
dK
= q
a
(w) (p

(w) 1) w
Average and marginal q

Optimal composition of the balance sheet: W and K

Average q:
q
a
(w) =
P(K, W) W
K
= p(w) w

Marginal q:
q
m
(w) =
dP(K, W)
dK
= q
a
(w) (p

(w) 1) w
Parameter Values
risk-free rate r = 6%
mean productivity shock (risk-neutral) = 18%
volatility of productivity shock = 9%
rate of depreciation = 10.07%
adjustment cost = 1.5
liquidation value l = 0.9
cash-carrying cost = 1%
proportional nancing cost = 6%
xed nancing cost = 1%

Benchmark: i
FB
= 15.1% and q
FB
= 1.23.
Liquidation
0 0.05 0.1 0.15 0.2 0.25
0.8
1
1.2
1.4
1.6
w
A. rm value-capital ratio: p(w)


rst-best
liquidation
l +w
0 0.05 0.1 0.15 0.2 0.25
5
10
15
20
25
30
B. marginal value of cash: p

(w)
0 0.05 0.1 0.15 0.2 0.25
!0.8
!0.6
!0.4
!0.2
0
0.2
cash-capital ratio: w = W/K
C. investment-capital ratio: i(w)


rst-best
liquidation
0 0.05 0.1 0.15 0.2 0.25
0
5
10
15
20
D. investment-cash sensitivity: i

(w)
cash-capital ratio: w = W/K
Optimal Financing
0 0.05 0.1 0.15 0.2
1
1.1
1.2
1.3
1.4
m( = 1%)
w( = 1%)
w( = 0)
A. rm value-capital ratio: p(w)


= 1%
= 0
0 0.05 0.1 0.15 0.2
1
1.2
1.4
1.6
1.8
B. marginal value of cash: p

(w)


= 1%
= 0
0 0.05 0.1 0.15 0.2
!0.3
!0.2
!0.1
0
0.1
0.2
cash-capital ratio: w = W/K
C. investment-capital ratio: i(w)


= 1%
= 0
0 0.05 0.1 0.15 0.2
0
2
4
6
8
10
12
cash-capital ratio: w = W/K
D. investment-cash sensitivity: i

(w)


= 1%
= 0
Dynamic hedging
0 0.05 0.1 0.15 0.2
!10
!8
!6
!4
!2
0
A. hedge ratio: (w)


costly margin
frictionless
0 0.05 0.1 0.15 0.2
!0.4
!0.2
0
0.2
B. investment-capital ratio: i(w)


frictionless
costly margin
no hedging
0 0.05 0.1 0.15 0.2
1.1
1.2
1.3
1.4
cash-capital ratio: w = W/K
C. rm value-capital ratio: p(w)


frictionless
costly margin
no hedging
0 0.05 0.1 0.15 0.2
1
1.5
2
2.5
3
cash-capital ratio: w = W/K
D. marginal value of cash: p

(w)


frictionless
costly margin
no hedging
Risk & return

Conditional :
(w) =

m
p

(w)
q
a
(w) + w
,
Idiosyncratic volatility and beta
0 0.2 0.4 0.6 0.8
1
1.2
1.4
1.6
1.8
2
A. rm value-capital ratio: p(w)


idio vol: 5%
idio vol: 15%
idio vol: 30%
0 0.2 0.4 0.6 0.8
1
1.1
1.2
1.3
1.4
1.5
1.6
1.7
B. marginal value of cash: p

(w)


idio vol: 5%
idio vol: 15%
idio vol: 30%
0 0.2 0.4 0.6 0.8
!0.3
!0.2
!0.1
0
0.1
0.2
cash-capital ratio: w = W/K
C. investment-capital ratio: i(w)


idio vol: 5%
idio vol: 15%
idio vol: 30%
0 0.2 0.4 0.6 0.8
0.6
0.8
1
1.2
1.4
1.6
1.8
cash-capital ratio: w = W/K
D. conditional beta: (w)/
FB


idio vol: 5%
idio vol: 15%
idio vol: 30%
Credit line
!0.2 !0.1 0 0.1 0.2
0.9
1.1
1.3
1.5
m(c = 0.2)
w(c = 0.2)
m(c = 0)
w(c = 0)
A. rm value-capital ratio: p(w)


c = 0.2
c = 0
!0.2 !0.1 0 0.1 0.2
1
1.2
1.4
1.6
1.8
B. marginal value of cash: p

(w)


c = 0.2
c = 0
!0.2 !0.1 0 0.1 0.2
!0.25
!0.15
!0.05
0.05
0.15
cash-capital ratio: w = W/K
C. investment-capital ratio: i(w)


c = 0.2
c = 0
!0.2 !0.1 0 0.1 0.2
0
3
6
9
12
cash-capital ratio: w = W/K
D. investment-cash sensitivity: i

(w)


c = 0.2
c = 0
Investment and q
!0.2 !0.1 0 0.1 0.2
1.14
1.16
1.18
1.2
1.22
1.24
1.26
1.28
1.3
cash-capital ratio: w = W/K
A. average q and marginal q


q
a
(c = 0.2)
q
m
(c = 0.2)
q
a
(c = 0)
q
m
(c = 0)
q
FB
!0.2 !0.1 0 0.1
0.8
0.9
1
1.1
1.2
1.3
cash-capital ratio: w = W/K
B. investment and q
q


q
a
q
m
q
m
/p

i
!0.2 !0.1 0 0.1
!0.1
!0.05
0
0.05
0.1
0.15
i
Main Results

Investment rst-order equation

marginal cost of investing =
marginal q
marginal cost of nancing

nancing: no target cash level, target leverage;

nancing regions:

payout

cash

credit

equity nancing (or liquidation)

Main Results

Investment rst-order equation

marginal cost of investing =
marginal q
marginal cost of nancing

nancing: no target cash level, target leverage;

nancing regions:

payout

cash

credit

equity nancing (or liquidation)

Main Results (continued)

risk management: cash, hedging, and asset sales

rm value and risk/return: idiosyncratic and

systematic risks

methodology: tractable dynamic economic framework