Equilibrium investment and asset prices under imperfect corporate control

Finance

IFA Working Paper

Dow J;Gorton G;Krishnamurthy A

James Dow

2005

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 behaviour 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.

Institute of Finance and Accounting

FIN 399

IFA Working Paper

No