Opportunity Cost of Capital for Entrepreneurs: A Reappraisal

Prabesh Luitel, Piet Sercu and Tom Vinaimont
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Prabesh Luitel: IESEG Paris-Lille
Piet Sercu: KU Leuven
Tom Vinaimont: Nazarbayev University, Graduate School of Business

No 2024/01, Working Papers from Nazarbayev University, Graduate School of Business

Abstract: For undiversified entrepreneurs, the Cost of Capital (CC) is often set so as to align the project's Sharpe Ratio (SR) with the market's. Inserting annualised weekly-return volatilities from newly-listed firms-100 percent, on average - Kerins, Smith and Smith (2004) obtain a typical CC of 57 percent. We show that portfolio theory requires CCs substantially above the SR-based ones but we also argue that 100 percent volatilities are excessive: purely income-oriented entrepreneurs may even be happy with CCs below 20 percent. We provide closed-form return-on-value CCs for complete and partial non-diversification, as well as genuine pricing formulas based on dollar cashflow moments.

Keywords: privately-held assets; undiversified investor; required return; committed owner; total-risk beta (search for similar items in EconPapers)
JEL-codes: G31 G32 (search for similar items in EconPapers)
Pages: 51 pages
Date: 2024-03
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