Tobin's Q, internal finance, and investment in a developing country: Evidence from a panel of Korean manufacturing firms

The purpose of this paper is to examine the effects of Tobin's Q and internal finance in the investment decision at the firm level, particularly in a developing country. To accomplish our purpose, we tested the Q model of investment with cash flow across different types of firms according to their financial characteristics such as "Group", dividend-income ratios, or total asset sizes, under the framework of assuming exogeneity of Q but allowing for a possible correlation of Q with firm specific effects in the study of 171 Korea manufacturing firms over sample period 1982-1989. We also focused on the change of financing and investment behaviors of firms after 1986 Korea stock market flourishing.; Let's describe our major findings. Firstly, Q is a significant determinant of investment and cash flow is also highly significant and large across different types of firms. Cash flow effect is found to be much stronger in a developing country, Korea than a developed country, U.S.A. Secondly, the direction of changes of effects of Q and cash flow after 1986 stock market flourishing varies across different types of firms, but Q is still significant and cash flow is also significant and sizable. Thirdly, the pattern of our results across different firms are robust with respect to the change of either estimation technique or specification of estimation equation, considering the empirical issues associated with Q model of investment. Furthermore, we also get the strong cash flow effects within sales accelerator model of investment.; Therefore, we conclude that Q is one of the significant determinants in explaining the investments. Furthermore, our results in a developing country, in line with other studies in developed countries, strongly confirm that internal finance represented by cash flow is significant and important determinant of firms' investment decisions, refuting the Modigliani and Miller hypothesis. We also confirm that firms' investment and financing behaviors vary across their heterogeneities, which imply that a representative firm theory may not be applied to different types of firms, because firms may have different access to capital markets and respond differently to changes of market conditions.