Owner's Lack of Diversification and the Cost of Equity Capital for a Closely Held Firm

Abstract

Abstract Capital market theory suggests that undiversified investors may have a higher cost of capital than do diversified investors. Private companies generally trade at a discount to similar publicly traded companies. From a discounted cash-flow viewpoint, this implies that the cost of capital for the private company is higher. We suggest that a large component of the private company discount is due to the entrepreneurial investor's lack of diversification. Using basic capital market theory, we provide a cost of capital model that depends on total risk faced by the entrepreneurial investor. We then propose a methodology based on a certainty-equivalent approach and Monte Carlo simulation to quantify this risk. We also provide a simple case to illustrate its application. Our results suggest that the risk borne by the undiversified entrepreneurial investor is a major contributor to the private company discount through the cost of capital.