Question

Explain why a high value for Tobin’s q predicts rising business investment. Discuss some of the difficulties in measuring Tobin’s q in practice.

Answer 1

The value of tobin q is given by = Equity market value / Equity book value

If this value is greater than 1, it implies that stock market places greater value on the firm's installed capital rather than the replacement capital. Thus, firms have an incentive to add to the installed capital and thus it will lead to rise in investment of the company.

The most important difficulty in determining the Tobin's q ratio is calculation of replacement and installed capital. It is difficult to estimate the replacement cost of total cost. Also, another problem is most of the companies use different versions of calculating replacement and installed capital. Thus, there is lack of uniformity in Tobin's q calculation.