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The Effects of Corporate Finance on Firm Risk-taking and Performance: Theory and Evidence

Author

Listed:
  • Toshihiro Okada

    (School of Economics, Kwansei Gakuin University)

  • Kohei Daido

    (School of Economics, Kwansei Gakuin University)

Abstract

Some firms may exhibit better operating performance than others because they undertake riskier projects: risk-return tradeoff. We develop a model to examine the effects of financial contracts on a firm fs choice between safer (lower risk, lower return) and riskier (higher risk, higher return) projects. The model shows that, assuming a competitive capital market (i.e., financiers with no monopoly power), three types of financial contracts (rollover loans, non-rollover loans, and new share issues) can each be an equilibrium contract, depending on conditions. While firms undertake griskier h projects when using non-rollover loans or new share issues, firms undertake gsafer h projects when using rollover loans. The model emphasizes the role of rollover loans (with passive monitoring) as a potential disciplinary device to suppress a firm fs risk-taking. The model generates several predictions about the determinants of a firm fs risk-taking and its performance. One key prediction of the model is that (risk-neutral) firms with closer bank relationships are more likely to use rollover loans and undertake gsafer h projects, even with a contestable capital market. We find novel empirical support for the model fs predictions.

Suggested Citation

  • Toshihiro Okada & Kohei Daido, 2009. "The Effects of Corporate Finance on Firm Risk-taking and Performance: Theory and Evidence," Discussion Paper Series 45, School of Economics, Kwansei Gakuin University, revised May 2009.
    • Handle: RePEc:kgu:wpaper:45
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    References listed on IDEAS

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    1. repec:bla:jfinan:v:53:y:1998:i:2:p:635-672 is not listed on IDEAS
    2. Kose John & Lubomir Litov & Bernard Yeung, 2008. "Corporate Governance and Risk‐Taking," Journal of Finance, American Finance Association, vol. 63(4), pages 1679-1728, August.
    3. Grinstein, Yaniv, 2006. "The disciplinary role of debt and equity contracts: Theory and tests," Journal of Financial Intermediation, Elsevier, vol. 15(4), pages 419-443, October.
    4. Jean Tirole, 2006. "The Theory of Corporate Finance," Post-Print hal-00173191, HAL.
    5. Gorton, Gary & Kahn, James, 2000. "The Design of Bank Loan Contracts," The Review of Financial Studies, Society for Financial Studies, vol. 13(2), pages 331-364.
    Full references (including those not matched with items on IDEAS)

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    More about this item

    Keywords

    corporate finance; corporate governance; firm risk-taking; firm performance; loan rollover;
    All these keywords.

    JEL classification:

    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill

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