A unified theory of Tobin’s q, corporate investment, financing, and risk management

This paper proposes an analytically tractable dynamic model of corporate investment and risk management for a financially constrained firm. Following Froot, Scharfstein, and Stein (1993), we define a corporation’s risk management as the coordination of investment and fi-nancing decisions. In our model, corporate risk management is a combination of internal liquid-ity management, financial hedging, investment, and payout decisions. We determine the firm’s optimal risk management policies as functions of the following key parameters: 1) the firm’s earnings growth and cash flow risk; 2) the external cost of financing; 3) the firm’s liquidation value; 4) the opportunity cost of holding cash; 5) investment adjustment and asset sales costs; and 6) the return and covariance characteristics of hedging assets the firm can invest in. The optimal cash inventory policy involves two endogenous barriers and the continuous adjustment in investment and hedging positions in between the barriers. Cash is paid out to shareholders only when the cash-capital ratio hits the upper barrier, and external funds are raised only when the firm has depleted its cash. Several new insights emerge from our analysis. For example, we find that the relation between marginal q and investment differs depending on whether cash o