The Effects of Corporate Finance on Firm Risk-taking and Performance: Theory and Evidence
Some firms may exhibit better operating performance than others because they undertake riskier projects: risk-return tradeoff. We develop a model to examine the effects of financial contracts on a firm fs choice between safer (lower risk, lower return) and riskier (higher risk, higher return) projects. The model shows that, assuming a competitive capital market (i.e., financiers with no monopoly power), three types of financial contracts (rollover loans, non-rollover loans, and new share issues) can each be an equilibrium contract, depending on conditions. While firms undertake griskier h projects when using non-rollover loans or new share issues, firms undertake gsafer h projects when using rollover loans. The model emphasizes the role of rollover loans (with passive monitoring) as a potential disciplinary device to suppress a firm fs risk-taking. The model generates several predictions about the determinants of a firm fs risk-taking and its performance. One key prediction of the model is that (risk-neutral) firms with closer bank relationships are more likely to use rollover loans and undertake gsafer h projects, even with a contestable capital market. We find novel empirical support for the model fs predictions.
|Date of creation:||May 2009|
|Date of revision:||May 2009|
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