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New estimates of the cost of capital for pharmaceutical firms

  • Giaccotto, Carmelo
  • Golec, Joseph
  • Vernon, John
Registered author(s):

    Academic researchers, as well as pharmaceutical firms themselves, often use the Capital Asset Pricing Model (CAPM) to estimate a firm's cost of capital. But the CAPM implicitly assumes that cash flows follow a random walk. This assumption is inconsistent with our finding that large U.S.-based pharmaceutical firms' cash flow growth rates display either momentum or mean-reversion. We show that growth rate momentum implies: (1) the systematic risk of a project increases monotonically with time to maturity of the cash flows; and (2) longer duration projects require a higher cost of capital. One of the practical implications of our results is that the traditional CAPM underestimates the cost of capital for some pharmaceutical firms by as much as 2.8%. These findings are quite relevant for the policy debate about the high rates of return earned by pharmaceutical companies, which some claim are pure rents and are not necessary to attract investors. Our theoretical and empirical analysis shows that high returns are often required to compensate for the higher systematic risk of long-duration pharmaceutical cash flows.

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    Article provided by Elsevier in its journal Journal of Corporate Finance.

    Volume (Year): 17 (2011)
    Issue (Month): 3 (June)
    Pages: 526-540

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    Handle: RePEc:eee:corfin:v:17:y:2011:i:3:p:526-540
    Contact details of provider: Web page: http://www.elsevier.com/locate/jcorpfin

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