Risk and Leverage Choices in Owner-Controlled Firms

Abstract

Private benefits of control distort the risk choices of owner-managers. In particular, when riskier projects entail a larger increase in cash flow than in private benefits (if successful), (more) equity financing renders the owner-manager (more) conservative, which lowers both expected payoff and pledgeable income. This novel cost of outside equity can be mitigated by issuing risky debt. In fact, risky debt and outside equity are complements for implementing a given risk choice, and an appropriately chosen mix of debt and equity allows the owner-manager to commit to the ex ante optimal risk level. Thus, our model provides a rationale for the co-existence of risky debt and outside equity derived from a simple risk choice problem in the presence of private benefits.

Keywords: Capital structure, risk-taking

JEL Classification: G32