Whose discount rates should be used during out licensing?
In my last VIEW post, I discussed the difference between Cost of Capital of a project versus Cost of Capital of a company. In this post we understand whose discount rate we should use when valuing cash flows from out licensing.
A Biotech company, X, out licenses a commercial product to Company Y and, based on the agreement, company X is entitled to receive a certain percentage of sales from company Y. Whose discount rate should be used to calculate the present value of License fees?
Before we delve into this, it is important to understand the risks associated with the cash flow. The risks that should worry us should be the risk of the cash flows from company Y and not from company X as the license fee is dependent on company Y. By this logic, if company X out licenses the commercial product to the government of the USA, the discount rate to be used should be the risk free rate that assumes the government is default free.
If company X decides to out license the commercial product to Pharma MNCs (such as Novartis or Pfizer), and if the cash flows are guaranteed contractually, what risks are we worried of? The only risks associated with these cash flows would be the default risk of these big companies. Hence, that risk will be encapsulated by their pre tax cost of debt and that should be used as the discount rate.
However, the matter gets complicated if out licensing is performed at an early stage. In this scenario, we are more worried about the risks of the project as the products are not ready to be commercialized and there is the possibility that product development might fail in the subsequent phases. How do we capture those risks?
We will discuss these in more detail in our forthcoming posts. Stay tuned!
– Saurabh Mishra