Entrepreneurs often face undiversifiable idiosyncratic risks from their business investments. We extend the standard real options approach to an incomplete markets environment and analyze the joint decisions of business investments, consumption/savings, and portfolio selection. For a lump-sum investment payoff and an agent with a sufficiently strong precautionary savings motive, an increase in volatility can accelerate investment, contrary to the standard real options analysis. When the agent can trade the market portfolio to partially hedge against investment risk, the systematic volatility is compensated via the standard CAPM argument, and the idiosyncratic volatility generates a private equity premium. Finally, when the investment payoff is a series of flows, the agent's idiosyncratic risk exposure alters both the implied option value and the implied project value, causing a reversal of the results in the lump-sum payoff case.

The presence of a well designed bankruptcy code is an important part of the financial architecture in developed economies. By allowing the creditors to seize the assets of the borrowers who fail to make contractual payments, the code generates beneficial ex ante effects on debt capacity and firm value. By giving the borrowers options to renegotiate their debt obligations and seek bankruptcy protection, the code increases the likelihood that borrowers may avoid inefficient ex post liquidation. As Hart (1999) notes, the code should balance ex ante firm value maximization with ex post efficiency. The bankruptcy codes in different countries weight this tradeoff differently and hence vary in terms of the distribution of rights and powers between borrowers and lenders. In this paper, we provide an inter-temporal framework to examine how the creditors’ liquidation rights and the distribution of ex post bargaining powers influence the firm’s investment and financing decisions, and affect ex ante firm value. We show that stronger equityholders ’ bargaining power lowers debt capacity, reduces firm value, and discourages growth option exercising. Our calibration suggests that the quantitative effects of ex post strategic renegotiation on ex ante firm value may be large.