Tobin's q, investment, and the endogenous adjustment of financial structure

Should q theory be modified to take account of financial structure? This paper analyzes a general equilibrium q model where financial structure affects firm value. Agency costs and taxes combine to yield an interior solution for the endogenous debt–equity ratio. Although q is still a ‘sufficient statistic’ for investment, the endogenous adjustment of financial structure alters the relation between the interest rate and investment. In this model an increase in the corporate tax rate could either raise or lower the steady-state capital stock. Furthermore, both q and investment could jump in opposite directions to that of their steady-state values.