Risk Avoidance under Limited Liability
Abstract When the expected flow returns from an investment is positive, bankruptcy carries a cost in terms of the future profit opportunities forgone. This paper demonstrates that, under limited liability, the one-shot gain from taking risky projects is offset by the long-term loss resulting from a higher probability of bankruptcy. In a multi-period model, the incentive problems associated with limited liability is less severe than what static models would suggest. Journal of Economic Literature Classification Numbers: D81, G33.