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