NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

Entrepreneurial Finance and Non-diversifiable Risk

Hui Chen, Jianjun Miao, Neng Wang

NBER Working Paper No. 14848
Issued in April 2009
NBER Program(s):   AP   CF   EFG

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.

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Document Object Identifier (DOI): 10.3386/w14848

Published: Hui Chen & Jianjun Miao & Neng Wang, 2010. "Entrepreneurial Finance and Nondiversifiable Risk," Review of Financial Studies, Oxford University Press for Society for Financial Studies, vol. 23(12), pages 4348-4388, December. citation courtesy of

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