Working Paper: NBER ID: w9758
Authors: James Dow; Gary Gorton; Arvind Krishnamurthy
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-the-money 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.
Keywords: corporate control; asset prices; investment; free cash flow
JEL Codes: G12; G30
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| imperfect corporate control (G34) | asset prices (G19) |
| aggregate free cash flow (G39) | asset prices (G19) |
| aggregate free cash flow (G39) | investment decisions (G11) |
| fluctuations in free cash flow (D25) | cyclical behavior of interest rates (E43) |
| stochastic variation in free cash flow (D25) | risk premia in corporate bonds (G12) |
| stochastic variation in free cash flow (D25) | risk premia in out-of-the-money put options (G13) |
| financial frictions (G19) | investment decisions (G11) |
| shocks (from financial frictions) (E44) | investment decisions (G11) |