Public-enterprise finance, broadly defined, encompasses mechanisms for raising funds, distributing profits, and absorbing losses. Although these functions are shared with private finance, public-enterprise finance typically differs in one important respect. When private firms raise capital on a commercial basis, they incur explicit obligations to repay specific amounts or shares of their profits in the future. These obligations reflect the opportunity cost of funds for claims of similar riskiness. Thus, in raising funds, they also specify the distribution of future profits and losses. In contrast, when public enterprises raise funds, they often do so without incurring such explicit obligations. Even when public enterprises borrow from commercial sources, they often do so with governmental guarantees, implicit or otherwise. As a result, public enterprises incur explicit financing costs that do not reflect the private opportunity cost of funds employed in the enterprises, let alone their social opportunity costs.

In this chapter we argue that the typical pattern of public-enterprise finance yields a distorted picture of the opportunity cost of funds employed and, hence, of the profitability and efficiency of public enterprise. Although this should have no real effect in an idealized setting where all public-enterprise decisions are made in light of the full set of social costs and benefits – including the social-opportunity cost of funds employed – we believe that in practice the way public enterprises are financed often contributes to inappropriate investment and operating decisions. In our view, the structure of management incentives is the primary link between financing and the strategic and operating decisions of a public enterprise.