What a difference risk makes in cost of capital calculations

Mike Pellegrino (Pellegrino and Associates) offered attendees at his BVR teleconference on An IP Cost of Capital Estimation Model, August 20th a simple example of the impact success rate estimates have on cost of capital determinations for early stage products and companies. Pellegrino's new model factors in observable market data for holding periods, success rates, and investor expectations to derive discount rates.

His example looks at a new cancer therapy that's about to enter preclinical trials--a classic example of early stage IP. Mike's CAPM for the IP estimates an unlevered cost of capital of 8.08%. He has data showing the historical success rate through the FDA is 15.8%, and the pharma company anticipates a 10 year holding period for the asset. Mike's model shows that the cost of capital for this situation is 29.98%.

However, "if the appraiser determines that this cancer treatment is particularly untested and risky," and decides that the success rate is only .1%, the cost of capital jumps to approximately 116%.

Pellegrino's point is that appraisers need observable market data to support their estimates for all components of early stage valuations--and that holding periods, investors' future expectations, and success rates are available from academic, financial, and other sources. His new model for IP cost of capital valuations if fully described in BVR's Guide to Intellectual Property Valuation.