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What Can we Learn from Stock Prices?: Cash Flow, Risk, and Shareholder Welfare

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Price is expected cash flows discounted at the risk-free rate plus an additional discount for risk exposure. Price equivalency does not always imply welfare equivalency: shareholders are not necessarily indifferent between a price increase of $1 from higher cash flows and the same $1 increase from lower risk exposure. Even in complete markets, if managers enjoy private benefits of control, the social planner may prefer lower risk exposure to a price-equivalent increase in firm value from greater investor protection. This has implications for event studies, the trade-off between principal costs and agency costs, and the link between macroeconomic risk and corporate governance. (JEL: D53, G12, G34, K22)
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Keywords: asset prices; firm value; securities law; shareholder welfare

Appeared or available online: December 14, 2018

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