Abstract
This paper develops a dynamic equilibrium model of capital structure and investment decisions. It explains the difference between the intra- and inter-firm variations in Q ratio. Its intra-firm variations are determined by a firm's own productivity process, while the inter-firm variations are determined by the cross-sectional heterogeneity in firms' production technologies. Understanding this cross-sectional heterogeneity can explain why leverage and profitability are important determinants of investment. The model also successfully matches the moments of aggregate market returns as well as cross-sectional stock return anomalies such as value, profitability, and investment premiums.
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