Present bias, risk management and capital structure

Standard credit risk models assume entrepreneurs maximize long-term equity value, despite significant evidence that entrepreneurs overvalue short-term profits and undervalue future long-term returns. We extend a classical credit risk framework by entrepreneurial myopia and show that myopic entrepreneurs favour lower volatility, while defaulting at a higher cash flow level. Our analysis distinguishes between sophisticated and naive entrepreneurs and shows that naivety leads to lower cash flow volatility and delayed default.

We analyse the interaction between unbiased debt-holders and myopic entrepreneurs. The desire for debt financing increases in the degree of the entrepreneur’s bias. Surprisingly, the entrepreneur’s myopia can actually increase the value of debt.