Dynamics of Entrepreneurship under Regime Switching

We propose a tractable model of entrepreneur dynamics where the investment conditions are stochastic. Applying the approach of stochastic control and optimization, we solve the dynamics of the entrepreneur's optimal investment, consumption and portfolio allocation under regime switching. We find that the interactions of precautionary savings and liquidation boundary advance/postpone motives generate rich implications for entrepreneur dynamics. Facing the threat of financial crisis, entrepreneurs build cash reserves and bring forward liquidation option exercise to mitigate downside risk. During the bad times, entrepreneurs value financial slack and postpone liquidation boundary to maintain the business and wait for the good state to come.


Introduction
The ability of regime-switching models to capture the cyclical features of real macroeconomic variables as proposed by Hamilton [1] is widely accepted.Since then, there has been growing interest in applications of regime-switching models into a wide class of financial and economic problems (see Honda [2], Guo, Miao, Morellec [3] among others).It's reasonable to believe that firm policy can be affected by regime shifts, since booms and recessions can have significant impact on the profitability or riskiness of both real and financial investment and the willingness to consume.Recent empirical studies show that firms' financing and investment behaviors change dramatically during the 2008 financial crisis (see Campello, Graham and Harvey [4], Ivashina and Scharfstein [5]).However, little theoretical research has been done on the relation between regime switching and the dynamics of entrepreneur's optimal consumption, investment and portfolio allocation.In this paper, we try to focus on the following interesting questions: How should entrepreneurs choose optimal consumption, investment, portfolio allocation and liquidation boundary when facing the threat of financial crisis in the future?How should entrepreneurs behave during a financial crisis?
To address these questions, we propose a quantitative model to study the dynamics of entrepreneur's optimal consumption, investment and portfolio allocation when the dynamics of decision variables are subject to discrete regime shifts at random times.Our model builds on the dynamic framework of entrepreneur's optimal policies (see Wang, Wang and Yang [6], henceforth WWY) by adding stochastic investment conditions.We have shown that when the entrepreneur faces uncertain macro conditions, it is optimal for them to hoard cash for precautionary reasons.In addition, the entrepreneur may choose the optimal liquidation boundary to eliminate the risk associated with regime switching.The analysis shows that precautionary savings and liquidation boundary advance/ postpone can have significant value and generate rich implications for entrepreneur dynamics.
The analysis in the present paper relates to two different strands of literature.First, it relates to the entrepreneurship literature.Hurst, Lusardi [7] used empirical methods to show that liquidity constraint induces the entrepreneur to initiate small-sized business.Herranz, Krasa and Villamil [8] studied the entrepreneur's behavior from the aspect of law, and found that the more riskaverse the entrepreneur, the more likely he executes liquidation option.Chen, Miao and Wang [9] developed a dynamic incomplete-market model of entrepreneurial firms building on Leland [10] and presented the implications of nondiversifiable risks on entrepreneurial finance.Hall and Woodward [11] studied the risk facing venture capital-backed entrepreneurial firms.Wang, Wang and Yang [6] proposed an incomplete-market q-theoretic model to study entrepreneurial dynamics, and found that precautionary motive, borrowing constraints, and capital illiquidity lead to underinvestment, conservative debt use, under-consumption, and less risky portfolio allocation.However, all these models assume that investment conditions are time-invariant.
Second, the present paper relates to a series of recent papers on regime switching.Driffill, Kenc, Sola [12] modeled the underlying asset return dynamic as a regime switching process to value a perpetual American call option.Honda [2] defined an unobservable regime variable in the economy as a continuous-time Markov chain and studied dynamic optimal consumption and portfolio choice in which the mean return of a risky asset shifts between regimes.Guo, Miao, Morellec [3] proposed a real option model in which the growth rate and volatility of the decision variable shift between different states at random times, and the results showed investment is intermittent and increases with marginal q under this policy.Chen [13] built a dynamic capital structure model and demonstrated how business cycle variations in expected growth rates, economic uncertainty, and risk premia influence firm's financing policies.One of our main contributions is the extensions of regime switching settings to the study of entrepreneurial dynamics, which includes entrepreneur's optimal consumption, investment and portfolio allocation decisions.
The paper that is most closely related to the present analysis is Bolton, Chen and Wang [14] (henceforth BCW).The authors analyzed dynamic corporate financial management for a financially constrained risk-neutral firm under stochastic financing conditions.They found that firms have precautionary cash hoarding and market timing motives to mitigate macroeconomic risk.One essential difference between the two papers is that we examine the dynamics of entrepreneurship while they focus on financially constrained public firms.Another important point of departure is that we assume stochastic investment conditions, whereas they consider stochastic financing conditions.Finally, we use nonexpected recursive utility function to separate risk aversion from the elasticity of intertemporal substitution (EIS).However, they consider risk-neutral pricing.
The remainder of the paper is organized as follows.Section 2 presents the model of entrepreneur dynamics under regime switching.Section 3 derives the model solution.Section 4 presents parameter choices and quantitative results.Section 5 concludes.

The Model
In this section, we propose our quantitative model to study the dynamics of entrepreneurship under regime switching.Our model is built on WWY [6] where i I K  is the firm's investment-capital ratio and   g i n increasing and convex function.To make the analysis simple and tractable ( see WWY [6], BCW [14] for example), we assume that is a where the parameter  measures the degree of the ad-justment cost.The higher  , the more adjustment cost occurs.
Finally, the entrepreneur can liquidate its assets at any moment.The flexibility of liquidation option makes the entrepreneur optimally manage his downside business risk.Liquidation gives a terminal value , where t s depends on the state t t s l K > 0 l s .A higher t s l implies a higher liquidation value.Obviously, we have G B , which makes liquidation in the good state much more attractive than in the bad state.Let l l   denote the entre- preneur's optimally chosen liquidation time.
Financial investment opportunities.In our model, the entrepreneur has financial investment opportunities to partially hedge his business risk.The entrepreneur allocates his liquid financial wealth between a risk-free asset which pays a constant rate of interest and the risky market portfolio (Merton [16]).The incremental return of the market portfolio over time period dt evolves as follows, where is the mean of the market portfolio return in state s and R  is the volatility of the market portfolio return in both states, and B is a standard Brownian motion.The correlation coefficient  between Z and is less than 1, which implies there exists nondiversifiable risk and the entrepreneur can't completely hedge his business risk.Let denote the Sharpe ratio of the market portfolio in state s , which is given by We denote W and X as the agent's financial wealth and the amount invested in the risky asset respectively.Given the entrepreneur's operating profit, investment, consumption and portfolio allocation, we can write the dynamics of liquid financial wealth as follows: where the firm term is the return on risk-free asset, the second and third terms are the return on market portfolio, the fourth term is the entrepreneur's consumption, and the last term is the firm's cash flows from operations.
We assume the entrepreneur can use capital as collateral to borrow and the borrowing is risk-free.Thus, the liquidation value of capital s must be greater than outstanding liability.So the following Equation holds, (1.9) The Entrepreneur's Objective.The entrepreneur maximizes his utility defined as,

 
, d where   , f C J for Epstein-Zin non-expected homothetic recursive utility (Duffie and Epstein [17]) is given by (1.12) In the above utility function, the parameter  is the elasticity of intertemporal substitution (EIS), and the parameter  is the coefficient of relative risk aversion.The parameter  is the agent's subjective discount rate.
To maximize his utility, the entrepreneur chooses investment, consumption and portfolio allocation subject to the collateralized borrowing limit (1.9).And the agent optimally chooses the liquidation time  .

Model Solution
The entrepreneurial value depends on both its capital stock and its cash holdings W . Thus, let K   , , J K W s denote the value function in state s .It satisfies the fol- lowing system of Hamilton-Jacobi-Bellman (HJB) Equations: , , , , .
The first term on the right side of the HJB Equation (1.13) represents the one-period utility.The second term represents the effect of capital stock changes on entrepreneurial value.The third and fourth terms represent the effect of the expected change in cashing holdings W and volatility of W on entrepreneurial value and the last term is the expected change of entrepreneurial value when the state changes form s to s  .
Next, we solve the first-order conditions (FOC) with respect to consumption , investment C I and portfolio choice X respectively.The FOC with respect to con- which shows the marginal utility of consumption C f is equal to the marginal utility of wealth W J at optimality.
The FOC with respect to investment I is given by , , which implies the entrepreneur's marginal cost of investing is equal to the marginal benefit of adding a unit of capital K J in state s .The FOC with respect to portfolio choice X is given by which states that the optimal amount investing in market portfolio is equal to the mean-variance demand (the first term on the right side) plus the hedging demand (the second term).
Then, we conjecture that the value function   where s b is given in appendix B and is the entrepreneur's certainty equaivalent (CE) wealth.

 ,
where  is given by Finally, the optimal scaled consumption c C K  , investment i I K  , and market portfolio allocationcapital ratio x X K  are given by is the marginal value of cash in state s .

Quantitative Results
In this section, we illustrate the quantitative results for given parameter choices of the model.First, we specify our choice of parameters.In state G, the expected productivity is set to be (Eberly, Rebelo, and Vincent [18]), while in state B is set to be 18% to reflect the worse investment condition in the bad state.Similarly, the mean return of market portfolio is set as and .We choose the liquidation parameter in state G in line with estimates provided by Hennessy and Whited [19].In the bad state, the capital liquidation value is set to , with an implied average length of a financial crisis being 2 years.This reasonable setting is borrowed from BCW [14].
The other parameters remain the same in the two states, and we set the parameters by widely-used numbers (see WWY [6]).The risk-free interest rate is .The subjective discount rate is set to equal to the risk-free rate, .As expected, average q in state G is higher than in state B.More remarkable is the fact that the difference between the average q in the two states is so large especially for lower levels of cash holdings.However, this phenomenon is not that obvious in the benchmarks.This difference in average q is due to differences in investment conditions.
In state G, the optimal liquidation boundary G w  .At this point, the firm hasn't reached the boundary compared with the benchmark.Further running the business would help the entrepreneur earn more profit.However, doing so would mean taking the risk that the state of nature switches to the bad state when the investment condition is much worse.The entrepreneur makes the trades off and optimally exercises the liquidation option by liquidating when hits the lower barrier 0.6592  w G w .However, the optimal liquidation boundary B w  0.6502  in state B is lower than the benchmark, which implies that the firm struggles to maintain the business and waits for the possible arrival of good state.
Panel C of Figure 1 underscores the significant impact of stochastic investment conditions on the marginal value of cash.The entrepreneur with low cash holdings values cash more in the bad state.In our model, the marginal value of cash in state B reaches , almost double However, in the bad state, the entrepreneur values his cash more than in the benchmark, no matter his financial slack is sufficient or not.Intuitively, the entrepreneur may value wealth less, aware of the possibility of the state of nature switching to the good state.It is incorrect, because the entrepreneur needs more cash to maintain the business and postpone the liquidation option exercise.
Panel D plots marginal value of capital K P , which is also referred to as the marginal .The entrepreneur with medium cash holdings values capital more in the bad state and the one with extreme low (near the liquidation boundary) and high cash holdings values capital more in the good state.When , the marginal approaches to average shown in Panel B.

Optimal Investment
Figure 2 plots investment-capital ratio and investment-liquidity sensitivity .The investment in the good state is higher than in the bad state for a give and the difference is especially large when is low.The entrepreneur's precautionary motive is stronger in bad times, so that we should expect to see the firm hoarding more cash.This is reflected in the lower levels of investment.From Panel A of Figure 2, it can be seen that the firm engages in large asset sales and divestment up to 12% and 18% of its capital in the good and bad states respectively for cash hoarding purpose.

 w w
Compared to the benchmark, investment in the good state is lower for the entrepreneur with sufficient financial slack.Aware of the threat of switching to the bad state, the entrepreneur cuts investment and hoards cash or precautionary purpose.However, the entrepreneur f  reduces disinvestment and even boosts investment to the boundary.When w is near the liquidation boundary, level higher than the benchmark near the liquidation the cash hoarding motive is dominated by the early liq-uidation option exercise motive, thus leading to the investment boost.In the bad state, the investment is higher than the benchmark since the possible arrival of the good state.Similarly, the investment in state B in lower than the benchmark when w is sufficiently low.Having the possibility of the state of nature switching to the good state in mind, the entr reneur cuts investment to maintain the business and wait for the good state to come.Panel B of Figure 2 shows the significant impact of regime switching on investment sensitivity in both sta  In fact, the entrepreneur needs to burn cash to bring forward the liquidatio option exercise.In the bad state, n the difference between c w x w and the benchmark when w is large is larger than that when w is near the liquidation boundary.Intuitively, the entrepreneur needs to hoard cash to postpone the liquidation option exercise.
Apparently, the im significantly pact of regime switching on portfolio allocation and consumption is different.Comparing Panel A and Panel B in Figure 3, one can find that portfolio allocation   x w in the transitory case is so close to the one in the mark case, except for the part near the liquidation boundary.However, the consumption experiences a large jump in both states between the transitory case and the benchmark case.Intuitively, it implies that the precautionary cash hoarding motive is mainly captured by consumption rather than portfolio allocation.bench

Conclusions
titative model to study the dynamics at when the entrepreneur faces unce ring favorable macroeconomic conditions, the cash ho We propose a quan of entrepreneur's optimal consumption, investment and portfolio allocation when the dynamics of decision variables are subject to discrete regime shifts at random times.Our model builds on the dynamic framework of entrepreneur's optimal policies by adding stochastic investment conditions.
We have shown th rtain macro conditions, it is optimal for them to hoard cash for precautionary reasons.In addition, the entrepreneur may choose the optimal liquidation boundary to eliminate the risk associated with regime switching.The analysis shows that precautionary savings and liquidation boundary advance/postpone can have significant value and generate rich implications for entrepreneur dynamics.
Du arding motive is reflected in the lower investment, consumption and portfolio allocation for the entrepreneur ith sufficient cash holdings.Interes w the need to burn cash to bring forward liquidation option exercise dominates the cash hoarding motive, thus making the boost of investment, consumption and portfolio allocation when the firm is near the liquidation boundary.During a financial crisis, the entrepreneur cuts investment, delays consumption, lowers portfolio allocations d sometimes engages in asset sales.This is especially true when the entrepreneur enters the crisis with low cash reserves.These predictions are consistent with the stylized facts about firm behaviour during the recent financial crisis.In prospect of the possible arrival of the good state, the investment, consumption and portfolio allocation is higher than the benchmark for the entrepreneur with sufficient wealth.As the firm is near the liquidation boundary, the entrepreneur brings investment, consumption and portfolio allocation back to the benchmark to maintain the business and wait for the good state to come.

Appendix A. Details for Theorem 1
onjecture that the value function is given by Equa-We c tion (1.17).Using homogeneity property of   , , J K W s , 7) for C , we can obtain Equation(1.25), (1.26) and (1.2I and X respectively.Substituting these results into Equation (1.13), we obtain the system of .Equations (1.18) and (1.19).
We consider the lower liquidation boundary ODEs, i.e W .When W W  , the entrepreneur liquidates the firm.Using the value-matching condition at W , we have is the agent's value function after liquidation and with no business.The entrepreneur's optim implies the following smooth-pasting condition at the    b w q w q w q r w B w q w w q w q b w q w q b w q When w converges to infinity, approaches to G q FB G q , B q approaches to FB B q and th efficient before e co w is zero: Solving Equations (1.2.3) and (1.
b w q w q w q r w w q w G w q w q b w q w q b w q (1. 2.8) K W s K  in each state.We substitute the FOCs with respect to , C I , X , the value function form and the scaled CE wealth into the HJB Equation (1.13), and then get the systems of ordinary differential Equations (ODE) for scaled CE wealth .The results are summarized in the following theorem.

7 5 ,
B l  to reflect the severe lack of liquidity during a financial crisis.The transition intensity out of state G is set at G which implies an average duration of 10 years for good times.The transition intensity out of state B is B  

2 .Figure 1
Figure 1 plots entrepreneur's CE wealth , average and net marginal value of cash W and marginal value of capital   s p w P

Figure 1 .
Figure 1.The entrepreneur's scaled certainty equivalent wealth   p w , private average

Figure 2 .
Figure 2. Investment-capital ratio   i w and investment-liquidity sensitivity    i w .All parameter values are given in Sec- near the liquidation boundary, which reveals the convexity character brought by the liquidation option.
It's easy to find that the graphs of Panel A and B are very si expected, the portfolio allocation in the good state is higher than the milar.does consumption.Similar to the investment, the entrepreneur chooses to accelerate consumption and financial investment when the firm approaches the liquidation boundary.Strikingly, as w increases near the liquidation boundary, which is counterintuitive.

Figure 3 .
Figure 3. Market po all rtfolio ocation-capital ratio   x w and consumption-capital ratio   c w .All parameter values are Comparing the transitory case with the benchmark case, W displays different dynamics.In good state, for an entrepreneur with sufficient financial slack, W