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Entrepreneurial Finance and Non-diversifiable Risk

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  • Hui Chen
  • Jianjun Miao
  • Neng Wang

Abstract

Entrepreneurs face significant non-diversifiable business risks. We build a dynamic incomplete markets 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.

Suggested Citation

  • Hui Chen & Jianjun Miao & Neng Wang, 2009. "Entrepreneurial Finance and Non-diversifiable Risk," NBER Working Papers 14848, National Bureau of Economic Research, Inc.
    • Handle: RePEc:nbr:nberwo:14848
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    More about this item

    JEL classification:

    • E2 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G31 - Financial Economics - - Corporate Finance and Governance - - - Capital Budgeting; Fixed Investment and Inventory Studies
    • 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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