The interest rate is a key determinant of firm investment. We integrate a widely used term structure model of interest rates, CIR (Cox, Ingersoll, and Ross (1985)), with the q theory of investment (Hayashi (1982) and Abel and Eberly (1994)). We show that stochastic interest rates have significant effects on investment and firm value because capital is medium/long lived. Capital adjustment costs have a first-order effect on investment and firm value. We use duration to measure the interest rate sensitivity of firm value, decompose a firm into assets in place and growth opportunities, and value each component. By extending the model to allow for endogenous capital liquidation, we find that the liquidation option provides a valuable protection against the increase of interest rates. We further generalize the model to incorporate asymmetric adjustment costs, a price wedge between purchasing and selling capital, fixed investment costs, and irreversibility. We find that inaction is often optimal for an empirically relevant range of interest rates for firms facing fixed costs or price wedges. Finally, marginal q is equal to average q in our stochastic interest rate settings, including one with serially correlated productivity shocks.
