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Entrepreneurial Finance and Non-diversifiable Risk

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Author Info
Hui Chen
Jianjun Miao
Neng Wang

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Abstract

Entrepreneurs face significant non-diversifiable business risks. We build a dynamic incomplete markets 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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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 14848.

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Date of creation: Apr 2009
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Handle: RePEc:nbr:nberwo:14848

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Find related papers by JEL classification:
E2 - Macroeconomics and Monetary Economics - - Macroeconomics: Consumption, Saving, Production, Employment, and Investment
G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
G31 - Financial Economics - - Corporate Finance and Governance - - - Capital Budgeting; Investment Policy
G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Capital and Ownership Structure

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