Final answer:
The WACC for the US Drug Company involves calculations based on the costs of equity and debt financing. Big Drug's demand for capital shifts between DPrivate and Dsocial, based on whether it can capture private or social benefits. This demand influences how much they're willing to borrow and invest in R&D, positioning the WACC as a crucial performance metric.
Step-by-step explanation:
The Weighted Average Cost of Capital (WACC) function for the US Drug Company, referred to in the context as Big Drug, would be calculated by considering both the costs of equity and debt financing, taking into account the proportion of each in the firm's capital structure. The WACC is used to evaluate investment decisions, as it represents the minimum return that a company must earn on its existing asset base to satisfy its investors, creditors, and other providers of capital.
Big Drug's demand for financial capital (DPrivate) is affected by the profits the firm anticipates. If Big Drug could capture all the social benefits from its investments in R&D, represented by the demand curve Dsocial, the firm's demand for capital would increase, and it would be willing to borrow and invest $52 million. However, due to only receiving a portion of these social benefits, the actual amount would be between DPrivate and Dsocial. The consideration of social benefits is crucial, as it highlights the potential disparity between private and social returns on investment, which can subsequently affect the firm's decisions regarding how much to invest in R&D.
As interest rates or borrowing costs influence WACC (in this case, 8%), the firm's decision to invest in R&D will also depend on the expected return against this cost of capital. Estimating the WACC would involve combining the cost of debt with the cost of equity based on the firm's target capital structure and can provide insight into how much the firm should invest in growth opportunities, like R&D, to maximize shareholder value while considering the social benefits of its products.