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Volume 29 Number 2 December 2004
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Do Shareholders Really Prefer Risky Projects? |
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Ning Gong
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Abstract |
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It is often argued that managers representing shareholders' interest tend to
undertake risky projects because equity resembles a call option on a firm's
assets. However, this conclusion is not generally true when bankruptcy
risk is explicitly modeled. This paper compares the relative strength of the
agency cost and the bankruptcy risk in determining managerial choice of
cash flow volatility in a continuous time framework. Assume the existing
debt has covenants which preclude additional borrowing and that
bankruptcy is triggered when the cash balance hits zero, I show that for
low levels of debt, shareholders prefer to minimize cash flow volatility. I
also work out the critical face value of the debt above which shareholders
are risk-seeking rather than risk-avoiding. In short, bankruptcy costs being
borne by equity mitigates shareholders' desire for risk.
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Download this article.
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Keywords |
| Asset Substitution Proposition; Cash Flow Volatility; Bankruptcy Cost |
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Contact DetailsNing GongMelbourne Business School, University of Melbourne, 200 Leicester Street, Carlton, VIC 3053 E-mail: n.gong@mbs.edu
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