Estimating the Cost of Capital for Pharmaceutical, Biotechnology, and Medical Device Firms
- Presenter:
Chair: Joel Hay; Discussant: TBA Tue June 6, 2006 15:30-17:00 Room 225
Author: Scott Harrington (harring@wharton.upenn.edu), Health Care Systems, Wharton School, University of Pennsylvania
Title: Estimating the Cost of Capital for Pharmaceutical, Biotechnology, and Medical Device Firms
Rationale: The financing, investment, 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. A full understanding of these decisions is also important for the design and administration of government review and approval of new compounds and devices.
Objectives: This study provides new insight into health care research and development decisions by investigating factors that influence the cost of equity capital for publicly-traded pharmaceutical, biotechnology, and medical device firms, a subject that has received relatively little attention in the literature. The primary objective is to explore analytically the link between firms’ characteristics and risk factors that affect the cost of capital.
Methodology: According to conventional finance theory, the risk characteristics of firms and their associated effects on the cost of capital are of central importance in making optimal investment decisions. The study draws from corporate finance theory to develop an analytical model of how firm-specific characteristics and the “real option” features of pharmaceutical, biotechnology, and medical device firms’ investments affect their cost of capital and then investigates the empirical relation between those factors and capital costs. Two frameworks are employed for estimating firms’ cost of capital: (1) the traditional capital asset pricing model (CAPM), and (2) the empirically-driven three risk-factor model of Fama and French.
Results: The study provides evidence concerning three main questions:
- How does the cost of capital vary across pharmaceutical, biotechnology, and medical device firms and within firms in each sector?
- How do firm characteristics, including levels of R&D spending, product diversification, real option features, and primary care versus specialist focus affect firms’ cost of capital through their effects on risk factors that are priced in capital markets?
- Can evidence on the relationship between firm characteristics and firm-level cost of capital estimates be used to develop reasonable estimates of the cost of capital for classes of products for use as inputs to both expected net present value analysis and real options valuation methods?
The results should be useful to corporate managers in developing efficient investment and financing strategies and relevant to public policy related to such investment.
