Industry Survival Rate, Entrepreneur Historical Performance and Personal Wealth: A Probabilistic Model for Optimizing SMEs Capital Structure

Abstract

Existing research approaches the return on investment expected by entrepreneurs from the perspective of the investor. This paper argues that this perspective is inadequate when applied to entrepreneurs of small and medium sized enterprises (SMEs). In fact, return on equity cannot be ascertained from financial reports or markets. Entrepreneurs cannot provide a figure since their decision to invest in the venture is driven by many other reasons over and above simple return on equity.

The solution suggested in this paper is to approach the issue by viewing the entrepreneurs as a special kind of lenders who expect a return for the risk they incur from the possible bankruptcy of the firm and the impact this would have on their personal wealth. We decompose the entrepreneur risk into a cluster risk (cluster survival rate) and a firm specific risk (historical unsuccess of the entrepreneur). We relate both through the introduction of a Markov transition probability matrix. The transition probabilities are modeled with a logit and estimated with Maximum-Likelihood. The overall risk is, then weighted by the percentage of personal wealth the entrepreneur invested in the venture both directly (as equity) and indirectly (as collateralized debt). In fact, collateralized debt bears both the cost of debt and a 'smoothed' cost of equity since in case of liquidation the entrepreneur will have to repay only the part of debt that will not be covered by firm’s assets. We work out the weighted average cost of capital considering that the financial structure of the firm is characterized by equity, collateralized debt and uncollateralized debt. In the paper the point of equilibrium between the cost of equity and the cost of collateralized debt as well as the optimal mix between equity and collateralized debt is worked out and discussed.