Investor Protection, Diversification, Investment, and Tobin's Q

Abstract:     
We develop a dynamic incomplete-markets model where an entrenched insider, facing imperfect investor protection and non-diversifiable illiquid business risk, makes interdependent consumption, portfolio choice, expropriation, corporate investment, ownership, and business exit decisions. Unlike in the frst-best, the insider's tradeoff between under-diversification costs and private benefits leads to the following results: (1) the firm either over- or underinvests, depending on firm size; (2) the insider's private valuation fundamentally differs from diversified investors valuation;(3) conditional CAPM holds for outside equity; (4) the insider demands an additional idiosyncratic risk premium; (5) the exit option and ownership dynamics are important for the insider to manage business risk.

Number of Pages in PDF File: 46

working papers series