Cost of Capital

Cost of Capital
Pfizer is the largest research based pharmaceutical company with a market capitalization of 140 billion dollars according to Amit Sing, from its Capital Marketing group. Pfizer uses productivity index as a model when it decides to accept or reject projects. When companies decide on projects for their capital budgeting they look at goals such as return on assets, growth in earnings per share, maximizing aggregate dollar earnings, or maximizing stockholders wealth through retained earnings. Pfizer's goal is to recoup research and development (R&D) cost and a set level of profit since any new pharmaceutical product it brings into the market has a seven to 10 year exclusive manufacturing patent. Pfizer employs a textbook Capital Asset Pricing Model (CAPM), which uses the weighted average of debt and equity in its capital base to calculate its cost of capital.
CAPM describes the relationship between risk and the expected return. To calculate CAPM, Pfizer uses the risk-free rate from the treasury market, the beta from historical performance of its stock against an index such as S&P 500, and the market risk premium or the expected return on the market. The market risk premium is the difference between the expected return on the market and the risk-free rate from the treasury market.
To calculate the weighted cost of debt, Pfizer calculates the net debt (the amount of debt held minus the amount of cash held) rather than the gross debt.   This leads to the primary capital structure of Pfizer as equity rather than debt based.
R&D is expensive in the pharmaceutical industry and can run into the billions by the time Pfizer goes through three or four phases of trials from inception to production of a new drug. Therefore, it does not raise funds project by project from the capital market, but rather by looking at the current project's productivity indicator. It assesses the Net Present Value (NPV) of the current projects and their profitability as well...
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