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Entrepreneurial Finance and Non-diversifiable Risk

  • 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)

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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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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