A Financial Model of the Firm: Risk and Portfolio Selection∗

We address explicitly the issue of risk in the theory of the firm. To that end, we present a model in which the shareholders’ portfolio selection of assets and the decisions of the firm are jointly determined through the market process. The model allows to study the role of markets and prices on the type of risky activities undertaken by a firm and the allocation of random profit among shareholders. By establishing an explicit link between the behavior of the shareholders and the firm’s, the real and financial sectors are integrated. On the one hand, the interaction of the shareholders in the financial market influence the behavior of the firm in the real market. On the other hand, the decisions of the firm affects the allocation of risk. In particular, the payoff of the risky asset depends on the level of output, and reflects the uncertainty that emanates from the real sector. We show that the interaction among the shareholders in the financial market yields a choice of output that takes account of the preferences of all shareholders. Moreover, financial access enables a firm to undertake a riskier project, while, at the same time, reducing the risk faced by each shareholder of the firm. Specifically, a firm with access to the financial market produces more than a firm without financial access. As output increases, the variance of real profit increases. However, the variance of each shareholder’s share of real profit is less than the variance of real profit for a firm without financial access.