Abstract

I develop a dynamic model of corporate investment with taxes, costly equity and debt financing, agency conflicts between shareholders and managers, and a parameterized time-varying pricing kernel. The framework allows me to explore both the cross section of returns and firms' financing choices. In the model, managers seek private benefits proportional to the sizes of the firms, leading to empire-building behaviors. Corporate governance is modeled explicitly as a mechanism for shareholders to discipline managers. The predictions of the model are consistent with the recent empirical findings: (1) firms with stronger governance outperform firms with weaker governance in booms and underperform these firms in recessions; (2) firms with weaker governance enjoy lower costs of debt financing and rely less on equity financing than firms with stronger governance do. I also empirically test the predictions of the model on expected stock returns.

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