Fin 571 - Learning Team Reflection: The Cost of Capital - Pfizer

Week Five Learning Team Reflection: The Cost of Capital - Pfizer

Vadrien Hugee, York Schwab and Cynthia Johnson

FIN 571

December 3, 2015

Juan Woods

The Cost of Capital - Pfizer

Every company faces corporate finance challenges.  In this reflection, Pfizer is examined.  Pfizer is the world’s largest research based pharmaceutical company, meaning they research, develop and test drugs before introducing them to the market (Parrino, "Concept Review Video: Cost of Capital").  Their worldwide revenue is $65 billion and their market cap is close to $140 billion, making them a gigantic company to study (Parrino, "Concept Review Video: Cost of Capital").  

Pfizer is part of a profitable yet risky business.  The company must conquer many challenges, such as determining the cost of capital, tax concerns, minimizing operational costs, optimizing capital structure, and the mix of business.  The business must depend on the net debt and not gross debt to allow additional cash to flow.  Pfizer must optimize their capital structure to collect funds available to invest in additional R&D projects with investors (Parrino, 2012).  

Ahmed Singh, works in the Capital Marketing Group in Pfizer’s treasury department.   Ahmed discusses some of the corporate challenges Pfizer faces.  One significant challenge involves the cost of capital.  The company has a very complex business model, but uses a very simple formula to determine their cost of capital.  Pfizer uses the capital asset pricing model to determine their cost of capital, which leads to a very simple question; what is the cost of capital? (Parrino, "Concept Review Video: Cost of Capital")  The cost of capital is the weighted average cost of debt and equity that a company holds in its capital base (Parrino, "Concept Review Video: Cost of Capital").  The capital asset pricing model describes the relation between risk and expected return (Parrino, 2012).  Drugs can cost Pfizer up to $1 billion to develop, so debt is a very large part of the equation.  Pfizer uses net debt that is debt less the cash reserves of a company.  For a company like Pfizer with cash reserves of $33 billion and debt of $42 billion, the net debt is around $9 billion, which will have quite the impact on the cost of capital (Parrino, "Concept Review Video: Cost of Capital").

Another challenge involves the high startup cost of a new product entering the marketplace.  The company must take into consideration the weight of the debt attributed to trail testing, taxes, liabilities and development.  Pfizer must function in a traditional way to assist with the cost of capital asset and weight of average cost to adsorb the weight of the debt.  Some companies may see this weight of debt as too risky and will choose to hold cash through an insurance policy.  This available cash will sustain the company during the failures. The business must depend on the net debt and not gross debt to allow additional cash to flow.  Pfizer must optimize their capital structure to collect funds available to invest in additional Research & Development (R&D) projects with investors (Parrino, 2012).