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Opportunity Cost of Capital for Entrepreneurs: A Reappraisal

Author

Listed:
  • Prabesh Luitel

    (IESEG Paris-Lille)

  • Piet Sercu

    (KU Leuven)

  • Tom Vinaimont

    (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.

Suggested Citation

  • Prabesh Luitel & Piet Sercu & Tom Vinaimont, 2024. "Opportunity Cost of Capital for Entrepreneurs: A Reappraisal," Working Papers 2024/01, Nazarbayev University, Graduate School of Business.
    • Handle: RePEc:asx:nugsbw:2024-01
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    JEL classification:

    • G31 - Financial Economics - - Corporate Finance and Governance - - - Capital Budgeting; Fixed Investment and Inventory Studies
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill

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