Scandinavian Working Papers in Economics

Ratio Working Papers,
The Ratio Institute

No 125: Q-theory of Investment and Earnings Retentions-Evidence from Scandinavia

Johan Eklund ()
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Johan Eklund: Ratio, Postal: The Ratio Institute, P.O. Box 3203, SE-103 64 Stockholm, Sweden

Abstract: In a frictionless milieu retentions should have no impact on investment behavior. However, empirical studies typically find that retentions are an important determinant of investment. Managerial discretion and financial constraints are two alternative explanations that have been suggested. This paper uses a panel of listed Scandinavian firms to examine the importance of retentions as a determinant of investment. Measures of Tobin’s Q, marginal q and sales accelerator are used to control for investment opportunities. Scandinavian firms are found to depend on retentions to a high degree, more so than in other developed economies. This high dependence on retentions suggests that the Scandinavian capital markets are suffering from allocational inefficiencies. Moreover, these market frictions appear too large to per se be caused by information asymmetries or managerial discretion phenomena. Possible institutional explanations are suggested.

Keywords: investment; liquidity; retained earnings; free cash flow; Tobin’s Q; marginal q

JEL-codes: G00; G30

36 pages, September 16, 2008

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