Cost of equity question
So let me state my understanding and you guys can tell me where I'm wrong. Cost of equity is used to calculate the cost of bearing systematic risk - the implicit assumption is the rational investor will have diversified away all idiosyncratic risk. Systematic risk can take numerous forms (aka factors), but most practitioners keep it simple and use market risk via the CAPM as the sole measure of systematic risk (let's ignore F-F and other multi factor models for now). Let's imagine a company that manufactures cardboard boxes. The performance of this company is likely highly correlated with performance of the overall market, and thus we can assume has a beta of circa 1. Assume risk free rate of 2%, market risk premium of 7%, and you can estimate a cost of equity of 9%.
Now, imagine a company that is working on developing a new drug. There is a 50% chance the drug works, and the company is valuable, and a 50% chance the drug fails and the company is worthless. The outcome of the drug's success is entirely independent of the performance of the broader equity markets, and therefore I'd think the beta should be somewhere between 0 and 1 (theoretically should be zero as there shouldn't be any covariance with the broader market, but think in practice it would be probably around 0.5 or so just given real world dynamics). Let's just say it's 0.5 for sake of argument. So cost of equity using CAPM would be 5.5%.
Now in theory I guess this makes sense - companies with lower systematic risk should have lower cost of capital. But in practice I think ventures with binary outcomes not correlated with broader markets would typically attract much more expensive capital (e.g., VC) vs. mature companies that rise and fall with the broader market. So how do you explain this? Is it that the ability to actually diversify away the idiosyncratic risk falls down in practice?