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On Risk Aversion and Investment: A Theoretical Approach

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  • John Fender
  • Peter Sinclair

Abstract

We develop a two-period model where a risk-averse entrepreneur decides on the size of an investment project and how to finance it. He can use debt and/or equity finance; an incentive compatibility constraint limits the extent to which the project can be financed with equity. With debt, he may, in certain circumstances, credibly threaten default to provoke renegotiation. Under pure equity finance, investment is efficient. There are conditions under which the first best can be obtained by a mixture of debt and equity finance. More generally, overinvestment may occur, but no project is undertaken with underinvestment.

Suggested Citation

  • John Fender & Peter Sinclair, 2006. "On Risk Aversion and Investment: A Theoretical Approach," Journal of Institutional and Theoretical Economics (JITE), Mohr Siebeck, Tübingen, vol. 162(4), pages 601-626, December.
    • Handle: RePEc:mhr:jinste:urn:sici:0932-4569(200612)162:4_601:oraaia_2.0.tx_2-r
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    References listed on IDEAS

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    1. Bester, Helmut, 1994. "The Role of Collateral in a Model of Debt Renegotiation," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 26(1), pages 72-86, February.
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    3. Bulow, Jeremy & Rogoff, Kenneth, 1989. "A Constant Recontracting Model of Sovereign Debt," Journal of Political Economy, University of Chicago Press, vol. 97(1), pages 155-178, February.
    4. Hart, Oliver, 1995. "Firms, Contracts, and Financial Structure," OUP Catalogue, Oxford University Press, number 9780198288817, Decembrie.
    5. Harris, Milton & Raviv, Artur, 1991. "The Theory of Capital Structure," Journal of Finance, American Finance Association, vol. 46(1), pages 297-355, March.
    6. Bolton, Patrick & Scharfstein, David S, 1996. "Optimal Debt Structure and the Number of Creditors," Journal of Political Economy, University of Chicago Press, vol. 104(1), pages 1-25, February.
    7. Robert Cressy, 2002. "Introduction: Funding Gaps," Economic Journal, Royal Economic Society, vol. 112(477), pages 1-16, February.
    8. Fender, John & Sinclair, Peter, 2000. "A Theory of Credit Ceilings in a Model of Debt and Renegotiation," Bulletin of Economic Research, Wiley Blackwell, vol. 52(3), pages 235-256, July.
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    Cited by:

    1. Peter Sinclair, 2011. "Deficits, Debts and Defaults - Past, Present and Future," Discussion Papers 11-20, Department of Economics, University of Birmingham.

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    More about this item

    JEL classification:

    • D92 - Microeconomics - - Micro-Based Behavioral Economics - - - Intertemporal Firm Choice, Investment, Capacity, and Financing
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill

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