Pfizer Inc.’S Cost of Capital and Capital structure
- Xiaoyue Shi
The costs of capital and capital structures for Pfizer Inc. and its two competitors Merck & Co. Inc. and Johnson & Johnson in the pharmaceutical industry are analyzed in this memo. When calculating the cost of common stock for the three companies, three different approaches including Capital Asset Pricing Model (CAPM), Discounted Cash Flow (DCF) and the bond yield plus risk premium are applied (Appendix A). For CAPM approach (Figure 1 & 3), the risk-free rate (rRF) used is the rate on the U.S. 10-year Treasury bonds, which is 1.66. The market risk premium (RPM) is the required return on the stock market minus rRF. The required market return used here is the average 20 years rates of return on S&P 500. With highest beta (0.71), Merck has the higher estimated cost of equity (6.167). Pfizer has lower estimated cost of equity (5.910) with lower beta (0.67). Because of the lowest beta (0.48), Johnson & Johnson has the lowest estimated cost of equity (4.697). For DCF approach (Figure 2 & 4), the stock price used is the current stock price. The expected growth rate (g) is the annualized growth rate based on the dividend growth over the past 10 years. Among the three companies, Johnson & Johnson has the highest estimated cost of equity due to its highest expected growth rate in dividends. Pfizer’s estimated cost of equity is much lower than Johnson & Johnson. Having the lowest expected growth rate in dividends, Merck has the lowest cost of equity. For bond yield plus risk premium approach (Figure 5), the bond yield (Figure 7) for Pfizer, Merck and Johnson & Johnson are 2.0724, 2.5553, and 1.9629 respectively. Since their betas are Pfizer 0.67, Merck 0.71 and Johnson & Johnson 0.48, and all below 1, the three companies’ judgmental risk premium estimated as 3.3, 3.4, and 3, respectively. According to the bond yield plus risk premium method, the estimated costs of equity are Pfizer 5.3724, Merck 5.9553, Johnson & Johnson 4.9629. The final estimated costs of equity for the three companies in this memo are the averages of the three approaches (Figure 6), and they are Pfizer 5.83, Merck 4.44, Johnson & Johnson 7.36. The three companies do not offer preferred stocks in public (Appendix B). Their costs of preferred stock would be zero. Although Pfizer offer Preferred stock for their employees, its costs of preferred stock still estimated as zero. According to the debt-rating organizations such as Moody’s, S&P, the three companies’ bond ratings are very high (Figure 7). The tax rates used for calculating the costs of debt are the average tax rates for the last four years (Appendix C, Figure 10). And their after-tax cost of debts are similarly low, for example, Pfizer 1.657, Merck 1.991, Johnson & Johnson 1.528 (Figure 9). When calculating the percentage of debt and common equity (Appendix D, Figure 12), the common equity used is the market value of equity, and the book value of company’s debt is used as a proxy of the market value of debt. According to the formula in Appendix D, the weighted average costs of capital (WACC) for the three companies are Pfizer 1.86, Merck 2.17, Johnson & Johnson 2.15. The WACCs are quit low for the three companies as pharmaceutical giants. The debt ratios for last four years for the three companies were all around 50% (Appendix E, Figure 13). For example, in 2008, Pfizer’s debt ratio was 48.1%, Merck was 55.2%, Johnson & Johnson was 49.9%; in 2009, Pfizer was 57.5%, Merck was 45.5%, Johnson & Johnson was 46.6%; in 2010, Pfizer was 54.7%, Merck was 46.3%, Johnson & Johnson was 45%; in 2011, Pfizer was 56.1%, Merck was 45.8%, Johnson & Johnson was 49.8%. Pfizer’s debt ratios were a little higher than its two competitors. But they all have quite similar capital structures with similar borrowing capacities. The three companies’ assets are financed with around 50%...
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