Dynamics of Entrepreneurship Under Incomplete Markets

45 Pages Posted: 24 Feb 2011 Last revised: 9 Nov 2011

See all articles by Chong Wang

Chong Wang

Naval Postgraduate School - Graduate School of Business and Public Policy

Neng Wang

Columbia Business School - Finance and Economics; National Bureau of Economic Research (NBER)

Jinqiang Yang

Shanghai University of Finance and Economics

Multiple version iconThere are 2 versions of this paper

Date Written: November 3, 2011

Abstract

An entrepreneur faces non-diversifiable business risk and liquidity constraints. We provide a unified framework that embeds these frictions to study interdependent business start-up/entry, capital accumulation/asset sales, portfolio allocation, consumption/saving, and business exit decisions. Liquid wealth mitigates financial constraints and critically influences the entrepreneur's decision making. An entrepreneur invests less in business, consumes less, and allocates less to the market portfolio in order to preserve liquidity for precautionary purposes. We develop the counterpart of the q theory of investment for firms run by non-diversified entrepreneurs, and propose corresponding measures for average q and marginal q. Corporate investment depends on both marginal q and the marginal value of wealth. The wedge between average q and marginal q is non-monotonic in liquidity. With illiquid capital stock, the endogenous liquidation option provides significant flexibility for the entrepreneur to manage downside risk, causes firm value to be convex in liquidity and investment to decrease in liquidity near the endogenous exit boundary. The flexibility to accumulate wealth before entering entrepreneurship is highly valuable, and the wealth effect is significant for entrepreneurship. The optimal entry decision critically depends on the outside option, the start-up cost, risk aversion, and wealth. Heterogeneity among entrepreneurs is thus important. Our model yields an operational framework to calculate the private equity idiosyncratic risk premium. Quantitatively, the interactive effects of incomplete-markets frictions and capital illiquidity on investment and value are significant.

Keywords: idiosyncratic risk premium, hedging, liquidity constraints, precautionary saving, portfolio choice, investment, entry, exit, the q theory of investment, real options

JEL Classification: G11, G31, E2

Suggested Citation

Wang, Chong and Wang, Neng and Yang, Jinqiang, Dynamics of Entrepreneurship Under Incomplete Markets (November 3, 2011). Available at SSRN: https://ssrn.com/abstract=1767429 or http://dx.doi.org/10.2139/ssrn.1767429

Chong Wang

Naval Postgraduate School - Graduate School of Business and Public Policy ( email )

555 Dyer Road
Monterey, CA 93943
United States

Neng Wang (Contact Author)

Columbia Business School - Finance and Economics ( email )

3022 Broadway
New York, NY 10027
United States

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Jinqiang Yang

Shanghai University of Finance and Economics ( email )

777 Guoding Road
Shanghai, AK Shanghai 200433
China

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