Cost of Capital for Pharmaceutical, Biotechnology, and Medical Device Firms

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 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, and (2) the Fama-French three-factor model. Evidence is provided of the relationship between risk, cost of equity, and the intensity of firms’ R&D expenditures. Controlling for firms’ principal sector (pharmaceutical, biotechnology, or device), R&D intensity, as measured by the ratio of R&D expense to total revenues, is positively related to market betas and thus the estimated cost of equity capital. Estimates of the Fama-French model imply a size-related risk premium in the cost of equity for small firms in each sector. Controlling for R&D intensity, average market betas differ significantly across sectors during the periods analyzed. Large bio-tech firms on average had large, negative, and significant book-to-market betas during 2001-2005, significantly lowering their estimated cost of equity capital, but the negative book-to-market betas and lower estimated cost of equity for large bio-techs disappeared during 2006-2008.