Do Shareholders Really Prefer Risky Projects?

Ning Gong
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Ning Gong: Melbourne Business School, University of Melbourne, 200 Leicester Street, Carlton, VIC 3053.

Australian Journal of Management, 2004, vol. 29, issue 2, 169-187

Abstract: It is often argued that managers representing shareholders' interests tend to undertake risky projects because equity resembles a call option on a firm's assets. However, this conclusion is not generally true when bankruptcy risk is explicitly modelled. This paper compares the relative strength of the agency cost and the bankruptcy risk in determining managerial choice of cash-flow volatility in a continuous-time framework. Assume the existing debt has covenants which preclude additional borrowing and that bankruptcy is triggered when the cash balance hits zero, I show that for low levels of debt, shareholders prefer to minimize cash-flow volatility I also work out the critical face value of the debt above which shareholders are risk-seeking rather than risk-avoiding In short, bankruptcy costs being borne by equity mitigates shareholders' desire for risk.

Keywords: ASSET SUBSTITUTION PROPOSITION; CASH-FLOW VOLATILITY; BANKRUPTCY COST (search for similar items in EconPapers)
Date: 2004
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Persistent link: https://EconPapers.repec.org/RePEc:sae:ausman:v:29:y:2004:i:2:p:169-187

DOI: 10.1177/031289620402900202

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