The Cost of Capital in Nonmarketed Firms

All western economies are mixed in the sense that there is both a marketed and a nonmarketed sector of firms. A natural question then arises: Should unincorporated business use higher or lower discount rates than incorporated business does? The same question has been a source of much controversy in public finance. Some authors, among them Arrow and Lind [1970] and Samuelson [1964], argue that public enterprises should use a lower discount rate because the government is better able to absorb risk and can more effectively diversify investments. Another group, which finds Hirshleifer [1966] and Diamond [1967] among its supporters, maintains that the discount rate should be the same for projects with comparable risk profiles, regardless of who undertakes them. As Diamond states: