TY - JOUR AU - Dow,James AU - Gorton,Gary AU - Krishnamurthy,Arvind TI - Equilibrium Asset Prices Under Imperfect Corporate Control JF - National Bureau of Economic Research Working Paper Series VL - No. 9758 PY - 2003 Y2 - June 2003 UR - http://www.nber.org/papers/w9758 L1 - http://www.nber.org/papers/w9758.pdf N1 - Author contact info: James Dow London Business School Sussex Place Regent's Park, London NW1 4SA UK Tel: 4402072625050 Ext3317 Fax: 4402077243317 E-Mail: jdow@london.edu Gary B. Gorton Yale School of Management 135 Prospect Street P.O. Box 208200 New Haven, CT 06520-8200 Fax: 203/432-8931 E-Mail: Gary.Gorton@yale.edu Arvind Krishnamurthy Kellogg School of Management Northwestern University 2001 Sheridan Road Evanston, IL 60208 Tel: 847/491-2671 Fax: 847/491-5719 E-Mail: a-krishnamurthy@northwestern.edu AB - 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. ER -