Question

Consider a firm that initially had an optimal level of capital. For each of the following events, describe

(i) how that event will affect the replacement cost of capital and the market value of capital,

(ii) how that will affect the Tobin’s q, and (iii) how that will affect the firm’s investment.

1) (5 points)An improvement in the production technology of the firm.

2) (5 points)A decrease in the number of employees hired.

3) (5 points)Destruction of some of the existing capital due to an earthquake.

4) (5 points)The price of capital goods increase

Answer 1

Formula for tobin q ratio= market value of asset/ replacement cost of capital

When market value rises more than replacement cost then only investment will take place.

1) Improvement in production technology increases the replacement cost of capital and market value of capital also rises. But proportion of market value rises more than replacement cost.

Therefore, Tobin q also rises and due to this investment also rises

2) A decrease in number of employees hired, replacement cost falls and market value remains unchanged.

So, tobin q falls and as a result investment also falls.

3) Destruction in capital due to earthquake, replacement cost rises more than market value.

So, tobin q ratio falls and as a result investment falls.

4) Price of capital goods rises, replacement cost remains unchanged and market value also rises.

So, tobin q rises and investment also rises.