The Q theory of investment: does uncertainty matter

Abstract

This paper includes uncertainty in the Q-model of investment. A structural Q-type investment model is derived, which contains the information on uncertainty effects of random variables that affect the future profitability of a firm. We use a panel of 82 Dutch firms to test whether the presence of uncertainty affects the performance of the Q-model. Our evidence shows that the volatility of profits and the volatility of the interest rate influence investment apart from Q. Moreover, the presence of uncertainty factors changes the structural parameters of the Q-model of investment. The results suggest that the unsatisfactory empirical performance of the standard Q-model of investment may be due to the omission of uncertainty considerations. In addition, Dutch firm-level evidence shows that severe uncertainty effects are associated with small firms and highly indebted firms, which are more likely to be in financial distress. This provides indirect evidence that the wedge between external financing and internal financing aggravates the effect of uncertainty on investment.