In the Concepts in Action video you watched this week, the speaker mentioned several challenges which led to his company's capital structure policy being different from what's discussed in traditional textbooks. Which of these challenges do you think is the strongest reason why their capital structure policy is different and why do you think so? (200 words)

Capital Structure Policy Amit Singh: A big part of Pfizers value chain is to identify the drug in the labs and then take them all the way to science, all the way to the market, to benefit the patients. It can take over ten years to develop a drug all the way from pre-clinical stages in the labs all the way to the market, and it can take, based on some studies, over a billion dollars of money in order to make this transition. Hi, my name is Amit Singh, and I work at capital market group in Pfizer treasury. My main responsibilities involve, as you can imagine by the name capital markets, maintaining and ascertaining the optimal capital structure for the company, which basically means how much debt, cash, and equity the company should maintain. Thats one of my prime responsibilities. The other things I look at are also supporting business development groups, so, you know, Pfizers often involved in mergers and acquisitions divestitures, more recently. We support evaluations of more day-to-day smaller projects, more finance-related projects, where the evaluation and discount rate-type inputs are needed from Treasury. So Pfizers capital structure policy, unlike what you would read in traditional textbooks, is more practical, and it has to do with minimizing a bunch of capital structure related costs, which have to do with tax rates, um, it could be related to your foster financial distress and other funding costs. If a product is two-thirds of the way through to the market and then some toxicity is developed in the product and the product fails, you have pretty much lost those hundreds of billions of dollars that you invested in the product to date. However, as a corporate finance person, I find several other aspects that are quite interesting and challenging. One of them is the fact that Pfizer and several companies the size of Pfizer hold what is called excess liquidity or excess cash on their balance sheets. What that means is when you try to do an optimal capital structure analysis for a company like Pfizer, you cantcannot just focus on the mix of the debt and the equity. In fact, you have to focus 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, is less than what you think it is. A couple of other items that I also find very fascinating, one is the fact that many of the pharmaceutical projects have real options embedded in them. What I mean by that is, if you have a long-term Pfizer project that is going from the druggoing from pre-clinical stages and research all the way to the market, somewhere along the line you have options in the process, where, for example, you can abandon the project. You have the option to accelerate the project, and all of these optionalities, so to speak, embedded in the projects, end up increasing the value project. And it is very difficult to capture this using a traditional discounted cash flow approach, which is what people try to do, given that real option analysis is quite difficult. The third big challenge which I find fairly unique to the pharmaceutical industry, is what I would refer to as the stair-step nature of the discount ratesand Ill explain that in a secondof a project that is an early stage drug development project versus a later stage. So, what do I mean by that? So lets assume you have two projects, one is a drug that is in phase one of development, the other one is the same drug, all else equal, is in the second phase of development. Now if you want to do a discounted cash flow analysis on both these drugs, do you use the same discount rate for both of those projects? And a lot of people, including myself, believe that the answer is no. In fact, we believe that the discount rate for the drugall else equal againthat is in the earlier stage of the project should be higher than the product that is in the later stage. And thats not just because of the probability of success being lower in the early stages, but it is more so because of some unique systematic risks that are given rise to for the products that are more early stage than later stage. So I find that, again an area of research thats far from resolved and fascinating and unique to pharmaceuticals. The last and the fourth item that I find alsoagain very unique and fascinating for the pharmaceutical industry, is the fact that it is very difficult to calculate the return on invested capital for a pharmaceutical company in any given year. And again, what do I mean by that? If you wanted to know whether a company was performing well or not, one metric that people often try to use is what is the return that the company is making on the invested capital that is invested in the company in any given year, as compared to the companys cost of capital? To the extent here that your returns are exceeding the cost of capital, your companys creating value and, if not, youre not creating value, or maybe youre destroying value. However, for a pharmaceutical company, given the long-term nature of the investment, a dollar invested today can potentially have a halo effect for several years to come, and it is very difficult to ascertain what the return of that dollar is in any given year. And that makes it very challenging to analyze the returns of a pharmaceutical company. Pfizers market capitalization is close to $140 billion. So how does Pfizer fund its R & D? Pfizer looks at R & D spend, or investment in R & D, as an expenditure or investment that is separate from its financing. So we do not look at each project as a project that needs to be separately funded. In fact we rank order the projects based on certain metrics, and are in a unique position to be able to fund all good projects that come our way. So we do not use project finance, and we do not go to try to raise debt or equity for individual R & D projects. The cash flows in the pharmaceutical industry, while the returns may be good for a successful product, are fairly uncertain. In a business that is this uncertain, it is very difficult to maintain a very high debt balance, because debt payments are certain and you have to make them. In order totherefore, in order to maintain and keep in mind the availability of the cash flows and the fact that you may go through several years of low productivity, and low cash generation, you need to acknowledge the fact, and you need to keep your debt balance accordingly low. In many ways that is very comparable to running a household because, just like in a good budget-making process in a household, you want to see how stable your job prospects are in the near term and even in the longer term, before you make a big purchase, especially if you take a big loan out, where the paymentsyou will have to make the payments and if you were to not make the payments, the repercussions would be dire and it would relate to bankruptcy. It is, in my mind, good financial policy is the same, whether it is in the household or a big successful company. In 2009, Pfizer acquired another research-based pharmaceutical company, Wyeth, for $68 billion. To the question of whether our capital policy has changed because of the Wyeth acquisition, the answer is yes. But, has theto the question has the policy changed permanently? I think the answer is no. To finance the Wyeth acquisition, which cost us $68 billion, we had to take on $23 billion of new debt. In order to be able to take on that much debt, we had to depart from our historical policy of very low debt, but that doesnt mean that we assume that that is the permanent debt level that we would stay at. In fact we have sincesince the Wyeth acquisition in 2009, weve been paying down debt, and we plan to settle down at a much lower debt level. One of the things that can cause us to re-look at and continuously reevaluate our capital structure is the availability, or our sense of the future availability in our cash flows. So anything in our business that fundamentally changes our cash flow availability, or is projected to change the cash flow availability in the future would make us re-look at our capital structure. What I mean by that is, for example, if we take on a business, or the proportion of our stable cash flow business increases in the future, as compared to the entire cash flow for the company, that would mean that we can take on more debt. And the reverse of that is if our proportion of our pharmaceutical business in the company grows, which is the more uncertain part of the business, then we would end up taking on less and less debt in the future and holding more and more cash.