Should a biotech company fund its project with the ROE greater than its cost of equity?
In our earlier post on valuation, we had discussed whether one should use the licensor’s or licensee’s cost of capital during out licensing. In this issue, we elaborate on the implications of using wrong discount rates.
Let’s assume a hypothetical company A (no debt) which is in the following businesses:
If the business development manager gets one project in biotechnology and his analysis states that the project would provide an ROE of 9.5%. Should the company fund this project?
It is true that the ROE from the new business in biotechnology is 9.5% which is higher than the cost of equity of the company but it is less than the hurdle rate that is expected from the projects in biotechnology.
An argument could be made that it’s the company’s money and it could be used to fund any project that provides ROE greater than the ROE of the company.
However, by doing that, we would expect the safer business such as medical services to attain the hurdle rate of 9.5% which is much higher than its cost of equity i.e. 7.27% and ultimately the safer business would not be able to compete and will keep getting smaller in the long run. Similarly, the riskier business which has to attain a hurdle rate of 11.32% will now have to attain a lower hurdle rate of 9.5% at the expense of safer businesses.
In sum, managers need to be careful while choosing the discount rates for the projects
– Saurabh Mishra