Ownership Concentration, Risk Aversion and the Effect of Financial Structure on Investment Decisions

Abstract

This paper examines the effect of capital structure on investment decisions when the firm is controlled by a large, risk-averse shareholder. Because of under-diversification, the controlling shareholder is more averse to risky projects than other shareholders whose portfolios are fully diversified, causing potential "under-investment" problems. We show that such under-investment problems can be mitigated by issuing risky debt because of the "risk-shifting" effect of debt. The paper demonstrates a unique equilibrium capital structure, involving both risky debt and equity, which is directly linked to the ownership structure. The analysis leads to empirical predictions about how ownership and capital structure are inter-related, and how capital structure is affected by such exogenous factors as the identity of the controlling shareholder and project risk. Existing empirical studies mostly support these predictions.

JEL Classification: G32