Week 5 Cost of Capital Video
Pfizer corporation is a research based pharmaceutical company in fact they are the world’s largest. They develop their own products, in a risky environment where a new product may have hundreds of millions of dollars invested in it and may fail and not be a viable product. Development of these types of products causes some significant cost of capital challenges for Pfizer.
Pfizer’s capital structure like many large publicly held corporations is made up primarily of debt, the money the firm has borrowed, and equity both from retained earnings and the equity investors have contributed by purchasing stock. Pfizer has eight billion outstanding shares of common stock in the market.
A key challenge the company faces is providing enough financing to fund these risky and sometimes long term R&D projects. They have significant revenue of $65B per year but that alone does not mean they will have ...view middle of the document...
Each product comes with its own unique risk features or systematic risk. Systematic risk is a risk experienced by all players in the market and it cannot be eliminated by diversification (Parrino, Kidwell, & Bates, 2012). Each project must meet the hurdle or the discount rate that is applicable to the product to be selected as a viable project that moves forward.
Pfizer tries to maintain an optimal capital structure for their company. Because of its risky business they must maintain an adequate supply of cash or liquidity to protect them in the event that an R&D project fails. There are opportunity costs associated with holding too much cash and they always want to minimize tax costs and funding costs. Additionally the business environment is always changing. Product mix can change causing profitability issues, economics can change and lately changes in the health care industry can threaten the cash flows of these companies. Balancing cash flow is critical to Pfizer’s success. If they are not successful they may not be able to handle the debt payments on their books that they thought they could handle just days before (reference video). Pfizer would want to use short term investments to invest excess cash in stocks and bonds and then liquidate those investments as they have a need for the cash to fund these R&D projects. These investments would help them offset the opportunity costs associated with holding too much cash.
When a company takes financial risks it must ensure that every product can potentially be a able to bring in adequate revenues. Many companies such as Pfizer have great visions however with many risky venues, a company must be able to maintain its cash or liquidity to ensure that they do not go bankrupt. Products that Pfizer develops and markets do not always pan out, but that doesn’t mean the company will stop trying because if they don’t try, they may never know which products are winners and which will fail. Pfizer can liquidate short term investments so that they can fund larger projects.
Parrino, R., Kidwell, D. S., & Bates, T. W. (2012). Fundamentals of Corporate Finance (2nd ed.). Hoboken, NJ: Wiley.