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First, spend a couple of sentences summarizing the textbelow.Then, answer the following In the text below , the speakermentioned several challenges which led to his company's capitalstructure policy being different from what's discussed intraditional textbooks. Which of these challenges do you think isthe strongest reason why their capital structure policy isdifferent and why do you think so?
Capital Structure Policy Amit Singh: A big part of Pfizerâsvalue chain is to identify the drug in the labs and then take themall the way to science, all the way to the market, to benefit thepatients. It can take over ten years to develop a drug all the wayfrom pre-clinical stages in the labs all the way to the market, andit can take, based on some studies, over a billion dollars of moneyin order to make this transition. Hi, my name is Amit Singh, and Iwork at capital market group in Pfizer treasury. My mainresponsibilities involve, as you can imagine by the name capitalmarkets, maintaining and ascertaining the optimal capital structurefor the company, which basically means how much debt, cash, andequity the company should maintain. Thatâs one of my primeresponsibilities. The other things I look at are also supportingbusiness development groups, so, you know, Pfizerâs often involvedin mergers and acquisitionsâ divestitures, more recently. Wesupport evaluations of more day-to-day smaller projects, morefinance-related projects, where the evaluation and discountrate-type inputs are needed from Treasury. So Pfizerâs capitalstructure policy, unlike what you would read in traditionaltextbooks, is more practical, and it has to do with minimizing abunch of capital structure related costs, which have to do with taxrates, um, it could be related to your foster financial distressand other funding costs. If a product is two-thirds of the waythrough to the market and then some toxicity is developed in theproduct and the product fails, you have pretty much lost thosehundreds of billions of dollars that you invested in the product todate. However, as a corporate finance person, I find several otheraspects that are quite interesting and challenging. One of them isthe fact that Pfizer and several companies the size of Pfizer holdwhat is called excess liquidity or excess cash on their balancesheets. What that means is when you try to do an optimal capitalstructure analysis for a company like Pfizer, you canâtâ¦cannot justfocus on the mix of the debt and the equity. In fact, you have tofocus on the fact that you have a lot of cash on the balance sheet,which means your net debt, which is the debt net of the cash, isless than what you think it is. A couple of other items that I alsofind very fascinating, one is the fact that many of thepharmaceutical projects have real options embedded in them. What Imean by that is, if you have a long-term Pfizer project that isgoing from the drugâ¦going from pre-clinical stages and research allthe way to the market, somewhere along the line you have options inthe process, where, for example, you can abandon the project. Youhave the option to accelerate the project, and all of theseoptionalities, so to speak, embedded in the projects, end upincreasing the value project. And it is very difficult to capturethis using a traditional discounted cash flow approach, which iswhat people try to do, given that real option analysis is quitedifficult. The third big challenge which I find fairly unique tothe pharmaceutical industry, is what I would refer to as thestair-step nature of the discount ratesâand Iâll explain that in asecondâof a project that is an early stage drug development projectversus a later stage. So, what do I mean by that? So letâs assumeyou have two projects, one is a drug that is in phase one ofdevelopment, the other one is the same drug, all else equal, is inthe second phase of development. Now if you want to do a discountedcash flow analysis on both these drugs, do you use the samediscount rate for both of those projects? And a lot of people,including myself, believe that the answer is âno.â In fact, webelieve that the discount rate for the drugâall else equalagainâthat is in the earlier stage of the project should be higherthan the product that is in the later stage. And thatâs not justbecause of the probability of success being lower in the earlystages, but it is more so because of some unique systematic risksthat are given rise to for the products that are more early stagethan later stage. So I find that, again an area of research thatâsfar from resolved and fascinating and unique to pharmaceuticals.The last and the fourth item that I find alsoâ¦again very unique andfascinating for the pharmaceutical industry, is the fact that it isvery difficult to calculate the return on invested capital for apharmaceutical company in any given year. And again, what do I meanby that? If you wanted to know whether a company was performingwell or not, one metric that people often try to use is what is thereturn that the company is making on the invested capital that isinvested in the company in any given year, as compared to thecompanyâs cost of capital? To the extent here that your returns areexceeding the cost of capital, your companyâs creating value and,if not, youâre not creating value, or maybe youâre destroyingvalue. However, for a pharmaceutical company, given the long-termnature of the investment, a dollar invested today can potentiallyhave a halo effect for several years to come, and it is verydifficult to ascertain what the return of that dollar is in anygiven year. And that makes it very challenging to analyze thereturns of a pharmaceutical company. Pfizerâs market capitalizationis close to $140 billion. So how does Pfizer fund its R & D?Pfizer looks at R & D spend, or investment in R & D, as anexpenditure or investment that is separate from its financing. Sowe do not look at each project as a project that needs to beseparately funded. In fact we rank order the projects based oncertain metrics, and are in a unique position to be able to fundall good projects that come our way. So we do not use projectfinance, and we do not go to try to raise debt or equity forindividual R & D projects. The cash flows in the pharmaceuticalindustry, while the returns may be good for a successful product,are fairly uncertain. In a business that is this uncertain, it isvery difficult to maintain a very high debt balance, because debtpayments are certain and you have to make them. In ordertoâ¦therefore, in order to maintain and keep in mind theavailability of the cash flows and the fact that you may go throughseveral years of low productivity, and low cash generation, youneed to acknowledge the fact, and you need to keep your debtbalance accordingly low. In many ways that is very comparable torunning a household because, just like in a good budget-makingprocess in a household, you want to see how stable your jobprospects are in the near term and even in the longer term, beforeyou make a big purchase, especially if you take a big loan out,where the paymentsâ¦you will have to make the payments and if youwere to not make the payments, the repercussions would be dire andit would relate to bankruptcy. It is, in my mind, good financialpolicy is the same, whether it is in the household or a bigsuccessful company. In 2009, Pfizer acquired another research-basedpharmaceutical company, Wyeth, for $68 billion. To the question ofwhether our capital policy has changed because of the Wyethacquisition, the answer is âyes.â But, has theâ¦to the question âhasthe policy changed permanently?â I think the answer is âno.â Tofinance the Wyeth acquisition, which cost us $68 billion, we had totake on $23 billion of new debt. In order to be able to take onthat much debt, we had to depart from our historical policy of verylow debt, but that doesnât mean that we assume that that is thepermanent debt level that we would stay at. In fact we havesinceâ¦since the Wyeth acquisition in 2009, weâve been paying downdebt, and we plan to settle down at a much lower debt level. One ofthe things that can cause us to re-look at and continuouslyreevaluate our capital structure is the availability, or our senseof the future availability in our cash flows. So anything in ourbusiness that fundamentally changes our cash flow availability, oris projected to change the cash flow availability in the futurewould make us re-look at our capital structure. What I mean by thatis, for example, if we take on a business, or the proportion of ourstable cash flow business increases in the future, as compared tothe entire cash flow for the company, that would mean that we cantake on more debt. And the reverse of that is if our proportion ofour pharmaceutical business in the company grows, which is the moreuncertain part of the business, then we would end up taking on lessand less debt in the future and holding more and more cash.
