To study the impact of stochastic interest rates and capital illiquidity on investment and firm value, we incorporate a widely-used arbitrage-free term structure model of interest rates into a standard <i>q</i>-theoretic framework. Our generalized <i>q</i> model informs us to use corporate credit-risk information to predict investments when empirical measurement issues of Tobin's average <i>q</i> are signicant (e.g., equity is much more likely to be mis-priced than debt) as in Philippon (2009). Consistent with our theory, wefind that credit spreads and bond <i>q</i> have significant predictive powers on micro-level and aggregate investments corroborating the recent empirical work of Gilchrist and Zakrajsek (2012). We also show that the quantitative effects of the stochastic interest rates and capital illiquidity on investment, Tobin's average <i>q</i>, the duration and user cost of capital, as well as the value of growth opportunities are substantial. These findings are particularly important in today's low interest-rate environment.
Journal of Financial Economics. Forthcoming.