Entrepreneurship and leverage dynamics without commitment

This paper builds a dynamic liquidity management model to examine the interdependent consumption-portfolio choices and debt financing problems when a risk-averse entrepreneur has leverage commitment friction. First, we find that low risk aversion leads to active debt buybacks, providing a novel rationale for the prevalent callable feature through the risk management channel. Second, high risk aversion generates a leverage ratchet effect. The distressed entrepreneur reduces consumption but takes on more risk to gamble for resurrection. To diversify business risk, the borrower accelerates the issuance of risky debt. Finally, we predict that the debt spiral effect (leverage mean reversion) is more likely to occur when the borrower is less (more) risk-averse, debt maturity is longer (shorter), or idiosyncratic risk is smaller (larger).