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Entrepreneurial Finance and Nondiversifiable Risk

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  • Hui Chen
  • Jianjun Miao
  • Neng Wang

Abstract

We develop a dynamic incomplete-markets model of entrepreneurial firms, and demonstrate the implications of nondiversifiable risks for entrepreneurs' interdependent consumption, portfolio allocation, financing, investment, and business exit decisions. We characterize the optimal capital structure via a generalized tradeoff model where risky debt provides significant diversification benefits. Nondiversifiable risks have several important implications: More risk-averse entrepreneurs default earlier, but choose higher leverage; lack of diversification causes entrepreneurial firms to underinvest relative to public firms, and risky debt partially alleviates this problem; and entrepreneurial risk aversion can overturn the risk-shifting incentives induced by risky debt. We also analytically characterize the idiosyncratic risk premium. The Author 2010. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please e-mail: journals.permissions@oxfordjournals.org., Oxford University Press.

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Article provided by Society for Financial Studies in its journal Review of Financial Studies.

Volume (Year): 23 (2010)
Issue (Month): 12 (December)
Pages: 4348-4388

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Handle: RePEc:oup:rfinst:v:23:y:2010:i:12:p:4348-4388

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Cited by:
  1. Panousi, Vasia & Papanikolaou, Dimitris, 2009. "Investment, idiosyncratic risk, and ownership," MPRA Paper 24239, University Library of Munich, Germany.
  2. Ghosh, Saibal, 2012. "Does R&D intensity influence leverage? Evidence from Indian firm-level data," MPRA Paper 38945, University Library of Munich, Germany.
  3. Laurence J. Kotlikoff & Jianjun Miao, 2010. "What Does the Corporate Income Tax Tax? A Simple Model without Capital," NBER Working Papers 16199, National Bureau of Economic Research, Inc.
  4. Wang, Chong & Wang, Neng & Yang, Jinqiang, 2012. "A unified model of entrepreneurship dynamics," Journal of Financial Economics, Elsevier, vol. 106(1), pages 1-23.
  5. Brent Glover & Oliver Levine, . "Idiosyncratic Risk and the Manager," GSIA Working Papers 2013-E25, Carnegie Mellon University, Tepper School of Business.
  6. Morten Sorensen & Neng Wang & Jinqiang Yang, 2013. "Valuing Private Equity," NBER Working Papers 19612, National Bureau of Economic Research, Inc.
  7. Strebulaev, Ilya A. & Whited, Toni M., 2012. "Dynamic Models and Structural Estimation in Corporate Finance," Foundations and Trends(R) in Finance, now publishers, vol. 6(1–2), pages 1-163, November.
  8. Caggese, Andrea, 2012. "Entrepreneurial risk, investment, and innovation," Journal of Financial Economics, Elsevier, vol. 106(2), pages 287-307.
  9. Paul Bergin & Ling Feng & Ching-Yi Lin, 2014. "Financial Frictions and Firm Dynamics," NBER Working Papers 20099, National Bureau of Economic Research, Inc.
  10. Missaka Warusawitharana, 2012. "Profitability and the lifecycle of firms," Finance and Economics Discussion Series 2012-63, Board of Governors of the Federal Reserve System (U.S.).
  11. Paolo Porchia & Pedro Gete, 2011. "Fertility and Consumption when Having a Child is a Risky Investment," 2011 Meeting Papers 563, Society for Economic Dynamics.

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