A Unified Theory of Tobin's q, Corporate Investment, Financing, and Risk Management

Abstract

We propose a model of dynamic investment, financing, and risk management for financially constrained firms. The model highlights the central importance of the endogenous marginal value of liquidity (cash and credit line) for corporate decisions. Our three main results are: (1) investment depends on the ratio of marginal q to the marginal value of liquidity, and the relation between investment and marginal q changes with the marginal source of funding; (2) optimal external financing and payout are characterized by an endogenous double-barrier policy for the firm's cashcapital ratio; and (3) liquidity management and derivatives hedging are complementary risk management tools.WHEN FIRMS FACE EXTERNAL financing costs, they must deal with complex and closely intertwined investment, financing, and risk management decisions. How to formalize the interconnections among these margins in a dynamic setting and how to translate the theory into day-to-day risk management and real investment policies remains largely to be determined. Questions such as how corporations should manage their cash holdings, which risks they should hedge and by how much, or the extent to which holding cash is a substitute for financial hedging are not well understood.Our goal in this article is to propose the first elements of a tractable dynamic corporate risk management framework-as illustrated in Figure 1-in which cash inventory, corporate investment, external financing, payout, and dynamic hedging policies are characterized simultaneously for a "financially constrained" firm. We emphasize that risk management is not just about financial hedging; instead, it is tightly connected to liquidity management via * Bolton is at Columbia University, NBER, and CEPR. Chen is at MIT Sloan School of Management and NBER. Wang is at Columbia University, NBER, and Shanghai University of Finance & Economics. We are grateful to Andrew Abel, Peter DeMarzo, Janice Eberly, Andrea Eisfeldt, Mike Faulkender, Michael Fishman, Xavier Gabaix, John Graham, Dirk Hackbarth, Cam Harvey, Christopher Hennessy, Pete Kyle, Yelena Larkin, Robert McDonald, Stewart Myers, Marco Pagano, Gordon Phillips, Robert Pindyck, Adriano Rampini, David Scharfstein, Jiang Wang, Toni Whited, two anonymous referees, and seminar participants at Boston College, Boston University, Columbia Business School, Duke, MIT Sloan, NYU Stern and NYU Economics, University of California at Berkeley, Yale, Maryland, Northwestern, Princeton, Lancaster, Virginia, IMF, Hong Kong University of Science and Technology Finance Symposium, Arizona State University, American Finance Association Meeting, the Caesarea Center 6th Annual Academic Conference, European Summer Symposium on Financial Markets, and Foundation for the Advancement of Research in Financial Economics for their comments. daily operations. By bringing these different aspects of risk management into a unified framework, we show how they interact with and complement each other.The baseline model we propose introduces only the essential building b...

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Investment timing with fixed and proportional costs of external financing

“…Because Y(t) is an increasing process, 4 the firm can save on financing costs by delaying investment. Although we, unlike Bolton, Chen, and Wang (2011) and Décamps, Mariotti, Rochet, and Villeneuve (2011), do not directly incorporate the costs of cash holdings, there is an opportunity cost of waiting. The firm will not receive increased cash flows during the waiting period but only after the expansion.…”

“…Bolton, Chen, and Wang (2011) extended the work of Décamps, Mariotti, Rochet, and Villeneuve (2011) into a more general framework by incorporating the dynamics of a firm's capital stock that can be increased by investment. In the integrated model, they showed that the marginal value of liquidity plays a central role in the firm's investment, financing, and payout decisions.…”

“…An incomplete list includes Bolton, Chen, andWang (2011), Cleary (1999), Fazzari, Hubbard, and Petersen (1988), Gomes (2001), Hennessy and Whited (2005), and Kaplan and Zingales (1997). 2.…”

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