Working Paper: NBER ID: w14848
Authors: Hui Chen; Jianjun Miao; Neng Wang
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.
Keywords: Entrepreneurship; Nondiversifiable Risk; Capital Structure; Leverage; Financing Decisions
JEL Codes: E20; G11; G31; G32
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| increased risk aversion (D81) | higher leverage choices (G11) |
| higher leverage choices (G11) | overall portfolio risk (G11) |
| risk aversion (D81) | earlier default on debt obligations (G33) |
| idiosyncratic risk (D81) | timing of defaults and cashouts (G33) |
| ignoring idiosyncratic risk premium (G40) | biases in estimating leverage ratios (G32) |