Suppose that we modify the model of the firm\'s investment decision by supposing

Question

Suppose that we modify the model of the firm's investment decision by supposing that any capital the firm has remaining at the end of the future period can be sold at the price p'K. (Remember in our model we assumed the capital could be sold at a price of one, in terms of consumption goods). Determine how this change affects the optimal investment rule for the firm. Suppose that we interpret p'K as the firm's stock price. If p'K increases, what effect does this have on the firm's optimal investment schedule? What does this imply about the relationship between investment and stock prices?

Explanation / Answer

By incorporating the financial aspects of investment into a model of optimal capital accumulation, it is shown that changes in "q" may affect the firm's capital structure as well as its investment policies. Although an increase in q generally implies an increase in investment, its impact upon capital structure is shown to depend upon how the marginal costs of leverage vary with investment. It is also demonstrated that marginal q equals a particular tax-adjusted average q which renders the relation between q and capital structure a testable hypothesis.

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