DMCA
Entrepreneurial Finance and Non-diversifiable Risk (2008)
Cached
Download Links
| Citations: | 22 - 7 self |
BibTeX
@MISC{Chen08entrepreneurialfinance,
author = {Hui Chen and Jianjun Miao and Neng Wang},
title = {Entrepreneurial Finance and Non-diversifiable Risk },
year = {2008}
}
Share
 |
 |
 |
 |
||
OpenURL
Abstract
Entrepreneurs face significant non-diversifiable business risks. In a dynamic incomplete-markets model of entrepreneurial finance, we show that such risks have important implications for their interdependent consumption/saving, portfolio choice, financing, investment, and endogenous default/cash-out decisions. Even though more risk-averse entrepreneurs default earlier for given debt service, they choose higher leverage ex ante for diversification benefits. Entrepreneurs demand not only a systematic risk premium but also an idiosyncratic risk premium due to the lack of diversification. We derive an analytical formula for the idiosyncratic risk premium whose key determinants are risk aversion, idiosyncratic volatility and the sensitivity of entrepreneurial value of equity with respect to cash flow. An entrepreneur’s option to use external equity improves diversification and raises the private value of firm, but it partially crowds out the value of diversification via external risky debt and hence lowers leverage. Finally, after debt is in place, when an entrepreneur chooses among mutually exclusive projects with different idiosyncratic volatilities, the effect of risk aversion tends to dominate the risk-shifting incentives. Only entrepreneurs with very low risk aversion engage in risk-shifting activities.
Keyphrases
entrepreneurial finance non-diversifiable risk idiosyncratic risk premium risk aversion private value portfolio choice risk-shifting activity low risk aversion engage systematic risk premium external equity dynamic incomplete-markets model interdependent consumption saving endogenous default cash-out decision hence lower entrepreneur demand risk-shifting incentive idiosyncratic volatility exclusive project risk-averse entrepreneur default debt service diversification benefit entrepreneurial value cash flow key determinant analytical formula external risky debt important implication entrepreneur option significant non-diversifiable business risk different idiosyncratic volatility
