Net Worth, Risk Taking and Investment

This paper analyzes how agency problems in nancial contracting determine risk-taking andinvestment. In perfect capital markets a risk-neutral rm would invest until the expectedmarginal return equals the interest rate. However, as rms with little net-worth face agencycost in nancial contracting the shadow cost of external funding are increased. It is often argued that this wedge forces rms to underinvest (the 'balance-sheet-effect'). However, thisclaim is premature. Firms with low net worth, hence high cost of external nancing, mighteven overinvest. We establish a robust though more subtile balance sheet effect. Agencyproblems in nancial contracting generate risk avoidance at the rm level even when allactors are risk neutral. This may explain why during major economic downturns rms andbanks shun risks that could be accepted in better times.