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Entrepreneurial Finance and Non-diversifiable Risk

Author

Listed:
  • Hui Chen

    () (MIT Sloan School of Management)

  • Jianjun Miao

    () (Department of Economics, Boston University)

  • Neng Wang

    () (Columbia Business School and NBER)

Abstract

Entrepreneurs face significant non-diversifiable business risks. We build a dynamic incompletemarkets model of entrepreneurial firms to demonstrate the important implications of nondiversifiable risks for entrepreneurs’ interdependent consumption, portfolio allocation, financing, investment, and business exit (cash-out and default) decisions. The optimal capital structure is determined by a generalized tradeoff model where risky debt provides significant diversification benefits. Non-diversifiable risks have several important implications: (1) more risk-averse entrepreneurs default earlier, but optimaly choose higher leverage, even though leverage makes his equity more risky; (2) lack of diversification causes entrepreneurial firms to underinvest relative to public firms, and allowing for risky debt partially alleviates this problem; (3) entrepreneurial risk aversion can overturn the risk-shifting incentives induced by risky debt. We also examine cash-out option and external equity as additional channels for diversification, and analytically characterize the idiosyncratic risk premium that under-diversified entrepreneurs demand for holding the firm.

Suggested Citation

  • Hui Chen & Jianjun Miao & Neng Wang, "undated". "Entrepreneurial Finance and Non-diversifiable Risk," Boston University - Department of Economics - Working Papers Series wp2009-018, Boston University - Department of Economics.
  • Handle: RePEc:bos:wpaper:wp2009-018
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    1. Wong, Kit Pong, 2015. "A regret theory of capital structure," Finance Research Letters, Elsevier, vol. 12(C), pages 48-57.
    2. 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.).
    3. Ewald, Christian-Oliver & Zhang, Hai, 2016. "Hedge fund seeding via fees-for-seed swaps under idiosyncratic risk," Journal of Economic Dynamics and Control, Elsevier, vol. 71(C), pages 45-59.
    4. Oliver Levine & Brent Glover, 2014. "Idiosyncratic Risk and the Manager," 2014 Meeting Papers 736, Society for Economic Dynamics.
    5. 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, pages 1-19.
    6. Liu, Yang & Yang, Jinqiang, 2015. "Optimal investment of private equity," Finance Research Letters, Elsevier, vol. 14(C), pages 76-86.
    7. Wang, Huamao & Yang, Zhaojun & Zhang, Hai, 2015. "Entrepreneurial finance with equity-for-guarantee swap and idiosyncratic risk," European Journal of Operational Research, Elsevier, vol. 241(3), pages 863-871.
    8. repec:eee:jbfina:v:81:y:2017:i:c:p:166-171 is not listed on IDEAS
    9. Panousi, Vasia & Papanikolaou, Dimitris, 2009. "Investment, idiosyncratic risk, and ownership," MPRA Paper 24239, University Library of Munich, Germany.
    10. Brent Glover & Oliver Levine, "undated". "Idiosyncratic Risk and the Manager," GSIA Working Papers 2013-E25, Carnegie Mellon University, Tepper School of Business.
    11. repec:eee:reveco:v:49:y:2017:i:c:p:596-611 is not listed on IDEAS
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    19. Wen, Chunhui & Xia, Xin & Yang, Jinqiang, 2017. "Idiosyncratic risk, the private benefits of control and investment timing," Economics Letters, Elsevier, vol. 153(C), pages 65-71.
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    More about this item

    Keywords

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

    JEL classification:

    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G31 - Financial Economics - - Corporate Finance and Governance - - - Capital Budgeting; Fixed Investment and Inventory Studies
    • E2 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment

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