Abstract

Abstract This paper develops a dynamic corporate finance model with macroeconomic risk to study the effect of conflicts between insiders and outside investors on the cost of equity. Agency conflicts, resulting from insiders’ willingness to favor their own interests at the expense of the firm are costly and reduce firms’ profit. They are also exposed to the business cycle, leading to time-varying agency costs. To test the model, I use top measures of agency conflicts and merge them with stock returns. The difference in the average value of these indexes in bad compared to good times is positively correlated to the cost of equity, even after controlling for preeminent market factors. Hence, firms with better governance in bad times have a lower cost of equity. Data are from 1990 to 2006.