Entrepreneurial Finance and Non-diversifiable Risk

Hui Chen (), Jianjun Miao and Neng Wang

No dp-180, Boston University - Department of Economics - The Institute for Economic Development Working Papers Series from Boston University - Department of Economics

Abstract: 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.

Keywords: Default; diversification benefits; entrepreneurial risk aversion; incomplete markets; private equity premium; hedging; capital structure; cash-out option; precautionary saving (search for similar items in EconPapers)
JEL-codes: E2 G11 G31 (search for similar items in EconPapers)
Pages: 44
Date: 2009-03
New Economics Papers: this item is included in nep-bec, nep-dge, nep-ent, nep-rmg and nep-upt
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Citations: View citations in EconPapers (2)

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Related works:
Journal Article: Entrepreneurial Finance and Nondiversifiable Risk (2010)
Working Paper: Entrepreneurial Finance and Non-diversifiable Risk (2009)
Working Paper: Entrepreneurial Finance and Non-diversifiable Risk
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