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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. 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. Andrea Caggese, 2006. "Entrepreneurial risk, investment and innovation," Economics Working Papers 1011, Department of Economics and Business, Universitat Pompeu Fabra.
  4. Laurence J. Kotlikoff & Jianjun Miao, 2013. "What Does the Corporate Income Tax Tax? A Simple Model Without Capital," Annals of Economics and Finance, Society for AEF, vol. 14(1), pages 1-19, May.
  5. 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.
  6. Paul Bergin & Ling Feng & Ching-Yi Lin, 2014. "Financial Frictions and Firm Dynamics," NBER Working Papers 20099, National Bureau of Economic Research, Inc.
  7. Wang, Chong & Wang, Neng & Yang, Jinqiang, 2012. "A unified model of entrepreneurship dynamics," Journal of Financial Economics, Elsevier, vol. 106(1), pages 1-23.
  8. Paolo Porchia & Pedro Gete, 2011. "Fertility and Consumption when Having a Child is a Risky Investment," 2011 Meeting Papers 563, Society for Economic Dynamics.
  9. 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.).
  10. Brent Glover & Oliver Levine, . "Idiosyncratic Risk and the Manager," GSIA Working Papers 2013-E25, Carnegie Mellon University, Tepper School of Business.
  11. Morten Sorensen & Neng Wang & Jinqiang Yang, 2013. "Valuing Private Equity," NBER Working Papers 19612, National Bureau of Economic Research, Inc.

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