"Investor Protection, Diversification, Investment, and Tobin's q"
Publication type: Working paper
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 first-best, the insider's tradeoff between private benefits and under-diversification costs leads to the following results: (1) the firm either over- or under-invests, 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.
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