The investment, financing, and risk management decisions of pharmaceutical, biotechnology, and medical device firms are fundamentally important to the development and availability of innovative treatments to enhance health outcomes and the quality of life. Economically efficient investment, including research and development, requires undertaking projects with positive “net present value,” i.e., projects for which the discounted value of expected net cash flows is positive, where the discount rate reflects investors’ opportunity cost of capital.
The cost of capital therefore has significant effects on investment decisions. It also affects the minimum product prices that are required to make basic research and particular R&D projects economically attractive.
Given long research and development cycles and relatively low scientific success rates for individual projects, the effects of the cost of capital on investment decisions can be particularly large for the pharmaceutical, biotechnology, and medical device sectors. Because firms in these sectors are primarily financed by equity (common equity issues and retained earnings), as opposed to debt, the relevant cost of capital for investment decisions is dominated by the cost of equity capital (see, e.g., Myers and Shyam-Sunder, 1996). Estimates of the cost of equity capital and understanding factors that influence the cost of equity are thus highly relevant to project development and policy issues, including drug and device pricing, and measurement of the average cost of developing a new drug or device (e.g., Dimasi, Hansen, and Grabowski, 2003; DiMasi and Grabowski, 2007; Vernon, Golec, and DiMasi, 2009).
This study provides new estimates of systematic risk and the cost of equity capital for the pharmaceutical, biotechnology, and medical device sectors using data for firms with publicly traded stock on U.S. exchanges (including foreign owned-firms) during 2001-2005 and 2006-2008. Two frameworks are employed for estimating firms’ risk and the cost of equity capital:
- (1) the capital asset pricing model (CAPM), and
(2) the empirically-driven three risk-factor model of Fama and French (F-F, 1992, 1993).
The CAPM is widely used by corporations, investment banks, and portfolio managers in valuation and capital budgeting. It is based on the simple notion that investors who are able to diversify at low cost will only demand compensation for bearing non-diversifiable risk. The CAPM posits that the risk premium required by investors for holding a particular security will depend on the sensitivity of the security’s return to returns on the market portfolio of risky assets, as measured by the security’s “beta.” Beta is a measure of a security’s market risk that cannot be diversified away by combining it with other securities in a portfolio.
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