NBER WORKING PAPER SERIES EQUILIBRIUM ASSET PRICES UNDER IMPERFECT CORPORATE CONTROL. James Dow Gary Gorton Arvind Krishnamurthy

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1 NBER WORKING PAPER SERIES EQUILIBRIUM ASSET PRICES UNDER IMPERFECT CORPORATE CONTROL James Dow Gary Gorton Arvind Krishnamurthy Working Paper NATIONAL BUREAU OF ECONOMIC RESEARCH 1050 Massachusetts Avenue Cambridge, MA June 2003 We thank Phil Bond, Bob Chirinko, Phil Dybvig, Joe Haubrich, and Jeremy Stein for their comments. We also thank members of seminar audiences at the University of Chicago, ECB-Frankfurt, Duke University, Northwestern University, University of Rochester, Stockholm School of Economics, NBER CF meeting and the NBER Summer Institute (EFEL) for helpful comments. The views expressed herein are those of the authors and not necessarily those of the National Bureau of Economic Research by James Dow, Gary Gorton, and Arvind Krishnamurthy. All rights reserved. Short sections of text not to exceed two paragraphs, may be quoted without explicit permission provided that full credit including notice, is given to the source.

2 Equilibrium Asset Prices Under Imperfect Corporate Control James Dow, Gary Gorton, and Arvind Krishnamurthy NBER Working Paper No June 2003 JEL No. G12, G30 ABSTRACT Shareholders have imperfect ontrol over the decisions of the management of a firm. We integrate a widely accepted version of the separation of ownership 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. Sharefholders 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 explain the cyclical behavior of interest rates and the yield curve. The stochastic variation in free cash flow sheds light on risk premia in corporate bonds and out-of-themoney put options. We show that the financial friction causes 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. James Dow Gary Gorton Arvind Krishnamurthy London Business School Department of Finance Department of Finance Sussex Place The Wharton School Northwestern University Regents Park University of Pennsylvania Kellogg School of Business London NW1 4SA Philadelphia, PA Sheridan Road United Kingdom and NBER Evanston, IL jdow@london.edu gorton@wharton.upenn.edu a-krishnamurthy@kellogg.nwu.edu

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