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Entrepreneurial Finance and Nondiversifiable Risk

  • Hui Chen
  • Jianjun Miao
  • Neng Wang

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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