Multistage investment, systematic risk premium and CAPM beta: empirical evidence from product development

Abstract

Recent theoretical literature suggests that the magnitude of the systematic risk premium for a multistage investment project is subject to various forces that may cause the premium to change across stages. To test this hypothesis, I investigate whether Capital Asset Pricing Model (CAPM) beta differs by product development stage in the biotechnology industry. To this end I estimate CAPM beta for various stages of drug development using Full-Information Beta (FIB) technique. Findings indicate that early stage drug development projects have higher CAPM beta than drugs in later stages of development or in production and marketing. The beta appears to decrease monotonically as a project approaches completion.

Keywords:

• multistage investment
• systematic risk
• CAPM
• R&D

JEL Classification:

• G31
• M21

Notes

¹ Because a priori it is impossible to predict which drug will be approved for marketing, the spending on failed compounds is factored in as a development cost of approved drugs.

² Jagannathan et al. (2011, p. 22).

³ Jagannathan et al. (2011, p. 22).

⁴ http://www.recap.com

⁵ SIC 2833 (medicinal chemicals), SIC 2834 (pharmaceutical preparations), SIC 2835 (in vitro/in vivo diagnostics), SIC 2836 (biological products), SIC 5122 (drugs and proprietary).

⁶ http://mba.tuck.dartmouth.edu/pages/faculty/ken.french (accessed 21 March 2007).

⁷ The baseline model with one lead and three lags is

The sum-beta is defined as the sum of the contemporaneous beta and betas for the lead and lag excess market returns.

⁸ This model is the best-performing CAPM specification reported by Dimson (1979). Both the lead and the third lag of excess market return are statistically different from zero.

⁹ Also the distributions of market value and share are highly skewed, with large biotechnology firms accounting for a bulk of market capitalization in the sample.

¹⁰ DiMasi (1995); Spilker (1999).

¹¹ Results available upon request.

¹² I use DiMasi (1995) and Spilker (1999) estimates. Because there is only a 23.5% probability of getting marketing approval for a drug entering clinical trials, the value of a typical project in a clinical trials stage relative to marketing stage is 1 divided by 0.235 or 4.26, and its value relative to pre-clinical trials stage is 5000/4.255 = 1175.

¹³ Shyam-Sunder classified biotechnology firms into 3 classes: Tier 1 – ‘mature’ firms with at least one approved drug, Tier 2 – firms with drug candidates in advanced stages of clinical testing and Tier 3 – firms without drug candidates in advanced stages of clinical testing.