Equilibrium Asset Prices under Imperfect Corporate Control

Shareholders have imperfect control over the decisions of the management of a firm. We integrate a widely accepted version of the separation of owership and control — Jensen’s (1986) free cash flow theory — into a dynamic equilibrium model and study the effect of imperfect corporate control on asset prices and investment. We assume that firms are run by empire-building managers who prefer to invest all free cash flow rather than distributing it to shareholders. Shareholders are aware of this problem but it is costly for them to intervene to increase earnings payouts. Our corporate finance approach suggests that the aggregate free cash flow of the corporate sector is an important state variable in explaining asset prices and investment. We show that the business cycle variation in free cash flow helps to explain the cyclical behavior of interest rates and the yield curve. The stochastic variation in free cash flow sheds light on risk premia on corporate bonds and out-of-the-money put options. We also show that the financial friction causes cash-flow shocks to affect investment, and causes otherwise i.i.d. shocks to be transmitted from period to period. Unlike the existing macroeconomics literature on financial frictions, the shocks propagate through large firms and during booms. ∗Respectively: LBS and CEPR, University of Pennsylvania and NBER, and Northwestern University. We thank Phil Bond, Bob Chirinko, Phil Dybvig, Joe Haubrich, Bryan Routledge, and Jeremy Stein for their comments. We also thank members of seminar audiences at the University of Chicago, ECBFrankfurt, Duke University, Northwestern University, University of Rochester, Stockholm School of Economics, Econometric Society Summer meeting, WFA meeting, NBER CF meeting and the NBER Summer Institute (EFEL) for helpful comments. e-mails: [email protected], [email protected], [email protected]