This week’s Concept Video, explains that the company uses the productivity index to determine which research and development product that the company will pursue. The research and development projects are prioritized by rank of value and funded if determined the product will have a high return for shareholders. The company also discussed the cost and capital. Productivity Index
The productivity index equation includes the net present value as the numerator which takes into account the value of the product provides to the patient population over the denominator the present value of cost the project incurs. The bigger the patient population the bigger the net present value. Each project has its own riskiness of cash flows and systematic risks and the company needs to meet the hurdle of discount rate that is applicable to the product. Cost and Capital
Based on the speaker, cost and capital would be the weighted average cost of the debt in equity that a company holds in the capital base. The textbook approach which is the capital asset pricing model to determine its cost of capital. Several things are viewed in the capital asset pricing model which is the risk free rate, the data of the company, index and the market risk premium and the weight of debt verse equity which brings the calculation of the cost of capital. The “Cost of Capital” video presented a real life example of the importance of cost of capital. Pfizer used the company’s net debt to calculate the cost of capital instead of using the gross debt. The net debt is equal to the gross debt minus the company’s cash on hand. Pfizer’s cash on hand is largely due to the nature of procuring cash flow from high risky projects. Pfizer’s net debt is $8 billion ($41bn – $33bn); thus, it is highly invested in equity instead of debt (Parrino, Kidwell, & Bates, 2012).
Pfizer’s most challenging concept is the optimal capital structure for the company. The speaker believes that Pfizer needs to take into account the cash or the liquidity the company needs to keep to have insurance for the research and development projects that fail. The industry is constantly changing, the availability in future cash flow might not be able to support the debt initially thought. The opportunity costs with the money that is being held for insurance, and also the tax challenges. For a company like Pfizer, it is imperative for it to have cash on hand to meet its short-term obligations. A pharmaceutical company that is invested in these risky projects has valuable projects but must be careful as well.
Parrino, R., Kidwell, D.S. & Bates, T.W. (2012). Fundamentals of Corporate Finance: Cost of Capital Video (2nd ed.). Hoboken, NJ: Wiley & Sons.