Aggregate Investment, Tobin's q and Insolvency.

Despite being theoretically appealing, the standard q-theory of investment performs very poorly in empirical work. This paper extends the q-theory to include the possibility that costs associated with the risk of insolvency affect the firm's investment decisions. Using aggregate data for the UK business sector, the model is estimated both as a structural equation and in a less restrictive dynamic form which also allows for mis-measurement of Tobin's q by average q. The paper finds clear evidence that aggregate investment is influenced by the risk of insolvency.