Equilibrium Investment and Asset Prices under Imperfect Corporate Control

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. Aggregate free cash flow of the corporate sector is an important state variable in explaining asset prices, investment, and the cyclical behavior of interest rates and the yield curve. The financial friction causes cash-flow shocks to affect investment, and causes otherwise i.i.d. shocks to be transmitted from period to period. The shocks propagate through large firms and during booms. ∗Respectively: LBS and CEPR, University of Pennsylvania and NBER, and Northwestern University. We thank Geert Bekaert, Philip Bond, Bob Chirinko, Phil Dybvig, Joe Haubrich, Thomas Philippon, Bryan Routledge, Paola Sapienza, Jeremy Stein, Amir Yaron and two anonymous referees for their comments. We also thank members of seminar audiences at the University of Chicago, ECB-Frankfurt, Duke University, University of Iowa, MIT, Northwestern University, University of Rochester, Stockholm School of Economics, Wharton, Econometric Society Summer meeting, AFA meetings, WFA meeting, NYU Five Star Conference, NBER CF meeting and the NBER Summer Institute (EFEL) for helpful comments. Leanardo Madureira provided excellent research assistance. e-mails: [email protected], [email protected], [email protected]