Reference no: EM13972334
Cost of Capital
Discuss some of the corporate finance challenges faced by this company.
Write a 350-700 word summary of your discussion.
Amit Singh: Pfizer is the world's largest research-based pharmaceutical company. Research-based pharmaceutical companies are companies that develop their own innovative pharmaceutical products. Pfizer's worldwide revenue is over $65 billion and its market gap is close to $140 billion.
Hi, my name is Amit Singh, and I work at capital market group in Pfizer treasury. I'm a petroleum engineer by background; I have a Bachelor's and a Master's in petroleum engineering. However, at the end of five years working with a company called Schlumberger Technologies in the Gulf of Mexico, I decided to go for an MBA. I quit working for two years, and once I came out of business school, I initially thought I would go back to the oil and gas sector. But then I did a summer internship at Pfizer, and never looked back since then. Pharmaceutical has its own corporate finance challenges (unintelligible)
The cost of capital is the weighted average cost of the debt and equity that a company holds in its capital base. In order to determine its cost of capital, we, at Pfizer, we use a very traditional textbook approach, which is the capital asset pricing model. So on the cost of debt side, starting with the debt piece, it is observable, and we all know what the cost of debt for a company like Pfizer is. On the equity side is where the capital asset pricing model comes in. In the capital asset pricing model, one of the inputs is the risk- free rate-again, observable-in the Treasury market. Then we look at the beta of the company, which is a calculated number based on the historical performance of Pfizer stock, which is an index such as S & P. And then the market risk premium, which is, unfortunately, not a very rigidly defined number. So taking into account all of this and the weight of debt versus equity we come to a calculation of cost of capital.
When we look at the amount of debt that goes into the weighted average cost of capital formula, we look at the net debt, not the gross debt. And by net debt, I mean the amount of debt that Pfizer holds in excess of the cash that Pfizer holds. So for example, today, with over 42 billion in debt and a little over 33 billion in cash, we would consider 7 or 8 million dollars of net debt in our capital structure, which means that our capital structure is primarily equity.
To bring a drug successfully to the market, all the way from the beakers in the lab, can be very expensive, and it could take, by some studies, it could take hundreds of millions of dollars, up close to even a billion dollars. The drug starts its journey toward the market in the labs, before it makes its step one into what we call First-in-Human or Phase One trials, where it is tested on healthy humans. Once successful from Phase One, it makes its way into Phase Two, where it is tested now on a disease population. The third phase that the drug then moves on to, which is Phase Three, is where it is applied to a very large population, where it is pitted against the placebos, and sometimes even other competitors in the market.
The data is accepted by the FDA, and the drug then goes to market, to be sold in a patent- protected manner for a period of... it could be eight to ten years. During this period there could be further clinical trials that are also expensive, so-called Phase Four trials, where you continue to monitor the acceptability of the drug on the really large patient population that is now taking it. If it wasn't for the patent process, where a company would be allowed to sell a drug exclusively in the market, an innovative pharmaceutical company would not exist, and the business of creating new, value-added drugs would just simply stop.
A firm's capital base consists of various types of...various sources of capital that the firm can borrow from the investor base. So for example debt is the amount of money that the firm has borrowed from the people who are loaning money in return for a promised interest. On the other hand, equity is what the investors in the stock have invested in the company, and there is no expectation of routine interest to be paid back for that...um...slice of the capital that the company has borrowed. So Pfizer's capital base consists of-as it is for most other companies-a broad mix of debt and equity. So we do have over $40 billion in debt currently outstanding and 8 billion Pfizer shares that are traded every day. So we have a combined capital base that we then are free to invest as we please in businesses that are hopefully NPV positive.
Pfizer's R & D is not funded project by project, based on going out in the market and issuing debt or equity just because you have one more R & D project that you want to invest in. In fact, the way we invest our R & D money is by prioritizing the existing products in the rank order of their value using certain financial metrics, and fund almost all the ones that we feel are a good return for our shareholders.
When looking at an R & D project, one of the tools or metrics that we look at is what is called the productivity index. What that is, is it is defined as when looking at the NPV of the project in the numerator, and the present value of the costs that you're going to be incurring in the project in the denominator. So, if you think about it, what this is is a typical "bang for buck" approach, which is how much return are you getting from this project, given how much money you have invested for the project. So using an approach such as this one, you could rank order your projects and then draw the line at the project where you believe that the returns are not substantial enough to warrant the risk.
In order to create this productivity index, which is the metric that we use for the evaluation of these projects, the numerator, which is the net present value of the project, takes into account the value this project would provide, or this product would provide to the patient population. For example, a broad applicability product, such as Lipitor, which is an anti-cholesterol product, it is...obviously it is applicable to a bigger patient population, and therefore can give rise to a bigger net present value, even at a relatively lower per pill price.
From a societal perspective, do you want to spend money on something that...a billion dollars on something that is for five people, or do you want to spend the same resources that society has given you on something that'll...it's a difficult question.
So each project, in our opinion, comes with its own riskiness, its own riskiness of cash flows and its own systematic risk, which means the discount rate for the project is unique to the project itself. So we don't believe that taking on a project by us versus a competitor of ours is any different. Because the project is the project, whether it goes to us, or to the other company. In each case the companies need to meet that hurdle, which is the discount rate that is applicable to the product. If the company cannot meet that hurdle, no matter what their previous discount rate is, it does not matter, and that project would be a failure.
One of the most challenging aspects of my role at Pfizer is to think about and plan for what is the optimal capital structure for the company. And, unlike what's available in traditional finance texts, where the text talks about optimizing the debt versus equity, we believe that a company such as Pfizer, in a risky business such as pharmaceuticals, needs to take into account the cash or the liquidity that is available, or that it needs to keep in order to have some sort of insurance policy against the potential R & D failures. We believe that the cash needs to be thrown in the mix as well. However there are other unique challenges, such as tax challenges, minimizing tax costs, minimizing your other costs, other funding costs that the company may incur in order to collect the capital that you need to invest. And also, potentially the opportunity cost of holding the cash that the company may be holding because of the insurance policy. Those all make it very challenging to come up with the right level of the capital structure that optimizes all these things that I just spoke of. And to add to that is the fact that the business environment is changing all the time, and potentially your business mix may be changing, your availability in your future cash flows may be changing, which means that you may or may not be able to handle the debt that you thought you could handle yesterday, you may not be able to handle tomorrow. So, I think that is one of the...optimal capital structure decision is one of the most challenging and difficult decisions of my position.