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Entrepreneurial Finance and Non-diversifiable Risk

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  • Hui Chen

    ()
    (MIT Sloan School of Management)

  • Jianjun Miao

    ()
    (Department of Economics, Boston University)

  • Neng Wang

    ()
    (Columbia Business School and National Bureau of Economic Research)

Abstract

Entrepreneurs face significant non-diversifiable business risks. We build a dynamic incompletemarkets model of entrepreneurial finance to demonstrate the important implications of nondiversifiable risks for entrepreneurs’ interdependent consumption, portfolio allocation, financing, investment, and business exit decisions. The optimal capital structure is determined by a generalized tradeoff model where leverage via risky non-recourse debt provides significant diversification benefits. More risk-averse entrepreneurs default earlier, but also choose higher leverage, even though leverage makes his equity more risky. Non-diversified entrepreneurs demand both systematic and idiosyncratic risk premium. Cash-out option and external equity further improve diversification and raise the entrepreneur’s valuation of the firm. Finally, entrepreneurial risk aversion can overturn the risk-shifting incentives induced by risky debt.

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Bibliographic Info

Paper provided by Boston University - Department of Economics in its series Boston University - Department of Economics - The Institute for Economic Development Working Papers Series with number dp-180.

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Length: 44
Date of creation: Mar 2009
Date of revision:
Handle: RePEc:bos:iedwpr:dp-180

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Keywords: Default; diversification benefits; entrepreneurial risk aversion; incomplete markets; private equity premium; hedging; capital structure; cash-out option; precautionary saving;

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Cited by:
  1. Saibal Ghosh, 2012. "Does R&D intensity influence leverage? Evidence from Indian firm-level data," Journal of International Entrepreneurship, Springer, vol. 10(2), pages 158-175, June.
  2. Wang, Chong & Wang, Neng & Yang, Jinqiang, 2012. "A unified model of entrepreneurship dynamics," Journal of Financial Economics, Elsevier, vol. 106(1), pages 1-23.
  3. Vasia Panousi & Dimitris Papanikolaou, 2011. "Investment, idiosyncratic risk, and ownership," Finance and Economics Discussion Series 2011-54, Board of Governors of the Federal Reserve System (U.S.).
  4. Laurence J. Kotlikoff & Jianjun Miao, 2010. "What Does the Corporate Income Tax Tax? A Simple Model Without Capital," Boston University - Department of Economics - Working Papers Series WP2010-013, Boston University - Department of Economics.
  5. Andrea Caggese, 2006. "Entrepreneurial Risk, Investment and Innovation," 2006 Meeting Papers 412, Society for Economic Dynamics.
  6. Paolo Porchia & Pedro Gete, 2011. "Fertility and Consumption when Having a Child is a Risky Investment," 2011 Meeting Papers 563, Society for Economic Dynamics.
  7. Morten Sorensen & Neng Wang & Jinqiang Yang, 2013. "Valuing Private Equity," NBER Working Papers 19612, National Bureau of Economic Research, Inc.
  8. Brent Glover & Oliver Levine, 2013. "Idiosyncratic Risk and the Manager," GSIA Working Papers 2013-E25, Carnegie Mellon University, Tepper School of Business.
  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. Neus Herranz, & Stefan Krasa, & Anne P. Villamil, 2013. "Entrepreneurs, Risk Aversion and Dynamic Firms," Centre for Growth and Business Cycle Research Discussion Paper Series 189, Economics, The Univeristy of Manchester.
  11. 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.
  12. 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.).

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