On risk aversion and investment: A theoretical approach

We develop a two-period model where a risk-averse entrepreneur decides on the size of an investment project and how to finance it. He can use debt and/or equity finance; an incentive compatibility constraint limits the extent to which the project can be financed with equity. With debt, he may, in certain circumstances, credibly threaten default to provoke renegotiation. Under pure equity finance, investment is efficient. There are conditions under which the first best can be obtained by a mixture of debt and equity finance. More generally, overinvestment may occur, but no project is undertaken with underinvestment.