Economics • Economic BasicsHard
Examine the implications of 'Tobin's q' ratio in corporate investment theory. When the market value of a firm's installed capital exceeds the replacement cost of that capital, what does a 'q' ratio greater than one signify?
A. Firms will find it unprofitable to invest in new physical capital assets.
B. Firms will be incentivized to expand investment because capital is valued higher on the market than its cost.✓ Correct Answer
C. The central bank must intervene by raising interest rates to curb speculative asset bubbles.
D. Corporate profitability is declining due to excessive overhead costs and diminishing returns.
💡 Solution & Explanation
James Tobin proposed that when q exceeds unity, the market valuation of capital is higher than its replacement cost, signaling firms to issue shares and invest in new plant and equipment. Alternative scenarios where q falls below one indicate that capital is worth less than its purchase price, discouraging investment. This ratio links financial asset markets directly to real economic investment decisions.
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