Several studies have attempted to estimate the pharmaceutical industry’s cost of capital, as a critical input in estimates of the cost and profitability of R&D. The cost of capital determines the interest cost on R&D funds invested and the discounted present value of life-time revenue flows. Using standard finance models such as the capital asset pricing model (CAPM), the conclusion is generally that the pharmaceutical industry is of average risk, with a beta approximately equal to one, a nominal cost of capital of roughly 15 percent or 10 percent in real terms in 1990 Although the industry is often perceived as highly risky because the success of any individual drug candidate is highly uncertain, such risks are readily diversifiable.
The point out the sequential nature of investment in R&D amplifies risk. Investing in R&D is equivalent to investing in compound lotteries and compound call options. Both beta and the opportunity cost of capital are higher for early stage R&D projects than for later stages. By implication, the average cost of capital is higher for small companies, that have several early-stage projects but no final products, than for large companies that have a diversified portfolio of products at various stages of the life cycle of development and commercialization.
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