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The Warwick MBAAssignment Cover Sheet

Submitted by: 9808937

Date Sent: 27th October 2014

Module Title: Corporate Finance

Module Code: IB9370

Date/Year of Module: September 2014

Submission Deadline: 27th October 2014

Word Count: 2482

Number of Pages: 32 (including cover sheet)

Question: In the first half of 2014, Pharmaceutical giant AstraZeneca rejected a takeover bid of £69.4bn from market leader Pfizer which equated to £55 per share.Were AstraZeneca right to reject the £69.4bn final offer from Pfizer? Should Pfizer come back with a new offer now the cooling off period has elapsed?

“This is to certify that the work I am submitting is my own. All external references and sources are clearly acknowledged andidentified within the contents. I am aware of the University of Warwick regulation concerning plagiarism and collusion.

No substantial part(s) of the work submitted here has also been submitted by me in other assessments for accredited courses of study, and I acknowledge that if this has been done an appropriate reduction in the mark I might otherwise have received will bemade.”

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A corporate financing review of Pfizer’s attempted takeover of AstraZeneca

Drug Wars:

Question: In the first half of 2014, Pharmaceutical giant AstraZeneca rejected a takeover bid of £69.4bn (equating to £55 per share) from market leader Pfizer.Were AstraZeneca right to reject the £69.4bn final offer from Pfizer? Should Pfizer come back with a new offer now the cooling off period has elapsed?

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1.0 Executive SummaryThis report looks at the attempted acquisition of the British‐Swedish pharmaceuticals firm AstraZeneca by the US company Pfizer in Q2 2014. The report seeks to answer two core questions:

1) Was the AstraZeneca board right to reject the final offer of £55/share offered by Pfizer?2) Now that the regulatory cooling off period has elapsed, should Pfizer attempt an acquisition again,

offering a higher price?The report begins by presenting a brief overview of the history of the deal. It then moves on to develop four forecasts of free cash flow for AstraZeneca, which can be seen in table 1.0 below.

The report then calculates a WACC for Pfizer, which includes the development of an Equity Rate through the use of CAPM and the calculation of a beta figure for Pfizer. The WACC is then recalculated using an industry beta. These calculations can be seen in the table to the right.

Free Cash Flows (£m)

Year 1 2 3 4 5 6 7 8 9 102013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023

Forecast 1 2483.0 5426.9 5653.2 2695.3 2497.8 2442.8 1164.6 3315.1 1455.9 5379.7 2803.6Forecast 2 2483.0 5426.9 5653.2 2695.3 2497.8 3030.2 1742.6 4211.9 2502.2 5303.1 3250.3Forecast 3 2483.0 5426.9 5653.2 2695.3 928.3 1195.3 1504.1 1860.4 2069.3 2299.1 2551.9Forecast 4 2483.0 5426.9 5653.2 2695.3 928.3 451.0 734.8 122.3 192.5 276.7 377.8

WACC

re 0.07426Beta 0.78WACC 0.067836 Industry re 0.07114Industry Beta 0.72Industry WACC 0.065227

The present value of the forecasts are developed, along with a horizon value to give four valuation figures. These can be seen in figure 1.0 (right) in comparison to Pfizer’s maximum offer.

Finally, The report concludes that the offer made by Pfizer was in line with the valuation and should have been accepted by AstraZeneca, and that Pfizer would be unwise to increase their offer above the level already made. 3

Table 1.0: Forecasted cash flow summary

Table 1.1: WACC calculation summary

Figure 1.0: Forecasted Present valuations for AstraZeneca

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ContentsSection 1: Executive SummarySection 2: Overview of the deal

Section 3: Free cash flow forecasts

Section 4: Weighted Average Cost of Capital (WACC)

2.0 Introduction2.1 Company Overview2.2 History of the deal2.3 The reason for the attempt

3.0 Historic free cash flows3.1 Free cash flow forecast Assumptions3.2 Free cash flow forecasts

4.0 WACC calculation4.1 Debt Rate4.2 Tax rate4.3 Debt / Value and Equity / Value split4.4 Equity Rate

4.41 Equity Rate calculation, risk free rate and EMRP4.42 Beta

4.5 Calculated WACC4.6 Industry WACC

4.61 Industry Beta4.62 Industry WACC

5.1 Discounted Cash flows5.2 Horizon Value

Section 5: Discounted Cash flows

Section 6: Discounted ValuationsSection 7: The tax HavenSection 8: ConclusionSection 9: Recommended further work Section 10: References

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2.0 IntroductionOn May 26th 2014 US based pharmaceutical company Pfizer abandoned their take‐over approach for British‐Swedish pharmaceuticals company AstraZeneca, ending a month‐long acquisition pursuit of the firm which saw a number of bids from Pfizer, topping out at £69.4bn (FT.com, 2014a)

The deal had been first tabled during secret talks between the two companies at the start of 2014. Throughout the first 5 months of 2014, Pfizer made three bids for the company to the board, none of which were ever put to shareholder vote.

The final bid made by Pfizer was for £55 per share, equating to a total of £69.4bn, and was a cash and stock offer at a split of c.45:55 cash to stock:

“AstraZeneca shareholders would receive, for each AstraZeneca share, 1.747 shares in the combined entity and 2,476 pence in cash, representing an indicative value of £55.00” (Pfizer, 2014a)

It is also worth noting that Pfizer’s pursuit of AstraZeneca generated a great deal of media interest and political concern which was intensified by the reneged promises made by Kraft during their acquisition of Cadbury in 2010 (BBC, 2014a). Although not cited as a reason, political influence is likely to have had some, albeit small, impact on the decision of the board to reject Pfizer’s offer.

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2.0 Company OverviewsBoth Pfizer and AstraZeneca are giants of the pharmaceutical world, with Pfizer ranking as the 19th largest corporation in the world (by Market Cap, PWC, 2014.). A brief summary of both firms can be found in the table below:

Pfizer AstraZeneca

Core business Biopharmaceuticals with “a leading portfolio of products and medicines that support wellness and prevention, as well as treatment and cures for diseases across a broad range of therapeutic areas” (Pfizer, 2014)

Biopharmaceuticals with “focus on Cardiovascular and Metabolic disease (CVMD); Oncology; and Respiratory, Inflammation and Autoimmunity (RIA)” (AstraZeneca, 2014)

Position in industry* First Eighth2013 Turnover $ 51,584 million £ 15,523 million2013 Profit before tax $ 10,674 million £ 1,972 millionTraded on NYSE LSENo. of shares 6,340,860,000 1,262,750,000Stock Value (8th October) $29.38 £42.61Market Capitalisation £ 186,294 million £ 86,988 millionNo. of Employees 77,700 51,600

Source: Data from respective company reports (Pfizer, 2014b; AstraZeneca, 2014a) and Global Company Intelligence (2014a, 2014b). Stock value from Yahoo Finance* Position in industry calculated from turnover/revenue

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Table 2.0: Key company information for Pfizer and AstraZeneca

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2.2 History of the dealPfizer first contacted the AstraZeneca leadership team to ask to open talks in late 2013. A high level timeline since that point can be seen below:

5th Jan 2014Initial talks in New YorkPfizer offers £58bn (£46.61 a share)

Jan MarFeb May

26th Apr 2014Pfizer try to re‐start talks, but without a firm offer on the table, AstraZeneca declines

28th Apr 2014Pfizer publically announces its intention to acquire AstraZenecaThe first mention of utilising the UK domicile tax haven is made

2nd May 2014Pfizer makes an offer of £63bn (£50 per share) Political interest intensifies

6th May 2014AstraZeneca updates strategy and sets a revenue target of £45bn by 2023

6th May 2014 onwardsCross party political interest and media coverage intensifies

13th & 14th May 2014 CEO’s of Pfizer and AstraZeneca appear before a commons select committee

Apr

18th May 2014A new £69.4bn offer (£55 per share) is made

19th May 2014AstraZeneca rejects the £69.4bn offer

19th May 2014Pfizer decides not to increase the offer and withdraws from the process

7Figure 2.0: Deal timelineSource: Guardian (2014a) and Pfizer (2014a, 2014c)

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2.3 The reason for the attemptIt appears that there are two core reasons for Pfizer’s attempt on AstraZeneca

Firstly, Pfizer wanted to diversify their drug pipeline and were specifically interested in the cancer drugs that AstraZeneca had been developing. Oncology treatments are profitable areas for pharmaceutical companies, and AstraZeneca’s pipeline is showing real promise. (AstraZeneca, 2014b)

Secondly, Pfizer wanted to shift its non‐US profits to a UK based company, thus shielding them from the US taxman (Guardian, 2014b). By moving Pfizer’s headquarters from the US to the UK, Pfizer could further reduce its tax bill because it could enjoy the UK’s 21% corporation tax rate (as opposed to 40% in US). The tax breaks do not end there though; In 2017 the ‘patent box’ rules come into effect, meaning that profits earned on products manufactured under UK‐held patents attract only 10% tax.

This report will primarily deal with the cash flows that AstraZeneca would generate for Pfizer, but consideration must be given to the value of the tax haven to Pfizer, and this is touched on briefly in the report.

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3.0 Historic free Cash flowsTo understand whether Pfizer were making a sound offer for AstraZeneca, we first need to understand the returns they were expecting to see from their acquisition. To do this, we need to calculate some forecasts of future free cash flows (as defined by Brealey et al, 2014) that AstraZeneca would produce for Pfizer.

Free cash flows in AstraZeneca have, over the past 5 reporting years, all been positive, but there has been little consistency. The table and graph below details the free cash flows from 2005 to 2013 (reporting years) (Fame, 2014)

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Figure 3.0: Historic free cash flows for AstraZeneca 2005 – 2013 (Fame, 2013)

Table 3.0: Historic free cash flows for AstraZeneca 2005 – 2013 (Fame, 2014)

‐4000

‐2000

0

2000

4000

6000

8000

10000

2005 2006 2007 2008 2009 2010 2011 2012 2013

AstraZeneca Historic Free cash flows (£m)

Historic Free Cash Flows (£m) 2005 2006 2007 2008 2009 2010 2011 2012 2013Profit after tax 2751 3098 2824 4227 4671 5161 6445 3892 1552Depreciation 615 512 593 815 584 701 699 629 608Investment in fixed assets 464 192 8852 5629 ‐1826 502 ‐928 2347 256Investment in working capital 472 ‐210 ‐2876 1003 1836 1540 ‐341 ‐1824 ‐579

Free cash flow 2430 3628 ‐2559 ‐1590 5245 3820 8413 3998 2483

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3.1 Free Cash flow forecast AssumptionsRevenuesIndustry analysts see AstraZeneca as a relatively stable business, and are forecasting revenues in 2014 and 2015 to show a slight decline of 5% (FT.com, 2014b). However, on May 6th 2014, AstraZeneca updated their strategy and set a revenue target of £45bn by 2023 (FT.com, 2014c). Working on an assumption that the industry analyst forecasts for 2014 and 2015 are correct, to achieve £45bn by 2023, revenues growth would need to be very ambitious. For this reason a number of forecasts will be created, one with the ambitious growth forecasted by AstraZeneca, and one building to a more manageable growth of 10% annually by 2017 and remaining at that level.

Cost of SaleWith regards to costs of sales, the pharmaceuticals industry requires very high investment in R&D. However, it is fair to assume that some synergies will be created from a merger of the two companies, especially central overheads(IT, finance, HR) and marketing costs. For this reason a reducing forecast of costs has been used in all forecasts.

Interest and DepreciationAs the table 3.1 shows, interest payments have been running at around 5% of long term debt, which has remained relatively static. For that reason the interest figure from 2013 of 5.19% will be used for all future forecasts. Equally, depreciation has been running historically at around 3% of fixed assets, so we will keep it at that level, and working capital has been around 20% of turnover.

2005 2006 2007 2008 2009 2010 2011 2012 2013Interest against total long term Debt ‐14.84% ‐30.09% 1.03% 4.26% 8.06% 5.68% 5.82% 4.58% 5.19%Depreciation against Fixed assets 9.54% 7.71% 3.83% 3.86% 3.03% 3.54% 3.70% 2.96% 2.83%Fixed assets as a % of sales 46.22% 49.09% 104.45% 96.93% 94.99% 93.17% 87.30% 123.28% 138.32%Working Capital as a % of sales 28.94% 28.29% 6.41% 8.97% 18.66% 25.08% 23.08% 18.39% 16.66%

10Table 3.1: Historic Interest, depreciation, fixed asset and working capital ratios for AstraZeneca 2005 – 2013 (Original data sourced from FAME database, October 2014)

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3.1 Free Cash flow forecast AssumptionsTaxTax rates have been forecast at the 20% rate until 2017 when they have been reduced to 15% to take into account the fact that a proportion of the profits will only attract the 10% ‘patent box’ rate.

Fixed AssetsFixed asset forecasts are much harder. As table 3.1 shows, for the past two reporting periods, fixed asset levels have been at around 130% of sales. However for four years prior to that they were around 90% of sales, and in 2005/2006 it was in the 50% region. As mentioned previously, the vast majority of the costs of sale in the pharmaceutical industry in the development costs of the drugs (R&D). This means that an increase in sales does not have to automatically equate to an increase in fixed costs. With an existing supply chain in place, it is conceivable that AstraZeneca could increase sales with much lower fixed cost investment. For this reason two forecasts for fixed asset costs have been used, one with major declines in fixed cost spending, and one with a more moderate decline.

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3.2 Free Cash flow forecasts

Year 1 2 3 4 5 6 7 8 9 102013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023

Turnover 15523.0 14746.9 14009.5 14710.0 16181.0 18608.1 21399.3 25679.2 30815.1 36978.1 44373.7Cost of sales + Operating costs 13282.0 12623.3 11992.1 12356.4 13430.2 15258.7 17333.5 20543.4 24652.0 29582.5 35498.9Operating Profit 2241.0 2123.5 2017.4 2353.6 2750.8 3349.5 4065.9 5135.8 6163.0 7395.6 8874.7Interest 269.0 269.0 269.0 269.0 269.0 269.0 269.0 269.0 269.0 269.0 269.0Profit before tax 1972.0 1854.5 1748.4 2084.6 2481.8 3080.5 3796.9 4866.8 5894.0 7126.6 8605.7Tax 420.0 370.9 349.7 416.9 372.3 462.1 569.5 730.0 884.1 1069.0 1290.9Profit after tax 1552.0 1483.6 1398.7 1667.7 2109.5 2618.4 3227.3 4136.8 5009.9 6057.6 7314.9Fixed assets 21472.0 17696.2 14009.5 13239.0 12944.8 13025.7 14979.5 15407.5 18489.0 18489.0 22186.8Working Capital 2586.0 2949.4 2801.9 2942.0 3236.2 3721.6 4279.9 5135.8 6163.0 7395.6 8874.7+ Depreciation 608.0 530.9 420.3 397.2 388.3 390.8 449.4 462.2 554.7 554.7 665.6‐ Investment in fixed assets 256.0 ‐3775.8 ‐3686.7 ‐770.5 ‐294.2 80.9 1953.9 428.0 3081.5 0.0 3697.8‐ Investment in working capital ‐579.0 363.4 ‐147.5 140.1 294.2 485.4 558.2 856.0 1027.2 1232.6 1479.1

Free cash flow 2483.0 5426.9 5653.2 2695.3 2497.8 2442.8 1164.6 3315.1 1455.9 5379.7 2803.6

AssumptionsTax rate 21.30% 20.00% 20.00% 20.00% 15.00% 15.00% 15.00% 15.00% 15.00% 15.00% 15.00%Sales growth ‐5.00% ‐5.00% 5.00% 10.00% 15.00% 15.00% 20.00% 20.00% 20.00% 20.00%Costs (% of sales) 85.56% 85.60% 85.60% 84.00% 83.00% 82.00% 81.00% 80.00% 80.00% 80.00% 80.00%Working capital (% of sales) 16.66% 20.00% 20.00% 20.00% 20.00% 20.00% 20.00% 20.00% 20.00% 20.00% 20.00%Depreciation (% of net fixed assets) 2.83% 3.00% 3.00% 3.00% 3.00% 3.00% 3.00% 3.00% 3.00% 3.00% 3.00%Fixed assests as a % of sales 138% 120.00% 100.00% 90.00% 80.00% 70.00% 70.00% 60.00% 60.00% 50.00% 50.00%

Notes: Aggressive sales growth & Large declines in fixed assets per sale

Forecast 1: Free Cash Flows (£m)

Forecast 1:

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Table 3.21: Free cash flow forecast 1

The following four tables detail the forecasted free cash flows that have been developed.

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Year 1 2 3 4 5 6 7 8 9 102013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023

Turnover 15523.0 14746.9 14009.5 14710.0 16181.0 17799.1 19579.0 21536.9 23690.6 26059.6 28665.6Cost of sales + Operating costs 13282.0 12623.3 11992.1 12356.4 13430.2 14595.2 15859.0 17229.5 18952.5 20847.7 22932.5Operating Profit 2241.0 2123.5 2017.4 2353.6 2750.8 3203.8 3720.0 4307.4 4738.1 5211.9 5733.1Interest 269.0 269.0 269.0 269.0 269.0 269.0 269.0 269.0 269.0 269.0 269.0Profit before tax 1972.0 1854.5 1748.4 2084.6 2481.8 2934.8 3451.0 4038.4 4469.1 4942.9 5464.1Tax 420.0 370.9 349.7 416.9 372.3 440.2 517.7 605.8 670.4 741.4 819.6Profit after tax 1552.0 1483.6 1398.7 1667.7 2109.5 2494.6 2933.4 3432.6 3798.7 4201.5 4644.5Fixed assets 21472.0 17696.2 14009.5 13239.0 12944.8 12459.4 13705.3 12922.1 14214.3 13029.8 14332.8Working Capital 2586.0 2949.4 2801.9 2942.0 3236.2 3559.8 3915.8 4307.4 4738.1 5211.9 5733.1+ Depreciation 608.0 530.9 420.3 397.2 388.3 373.8 411.2 387.7 426.4 390.9 430.0‐ Investment in fixed assets 256.0 ‐3775.8 ‐3686.7 ‐770.5 ‐294.2 ‐485.4 1245.9 ‐783.2 1292.2 ‐1184.5 1303.0‐ Investment in working capital ‐579.0 363.4 ‐147.5 140.1 294.2 323.6 356.0 391.6 430.7 473.8 521.2

Free cash flow 2483.0 5426.9 5653.2 2695.3 2497.8 3030.2 1742.6 4211.9 2502.2 5303.1 3250.3


Notes: More modest sales growth & Large declines in fixed assets per sale


Forecast 2:

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Year 1 2 3 4 5 6 7 8 9 102013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023

Turnover 15523.0 14746.9 14009.5 14710.0 16181.0 17799.1 19579.0 21536.9 23690.6 26059.6 28665.6Cost of sales + Operating costs 13282.0 12623.3 11992.1 12356.4 13430.2 14595.2 15859.0 17229.5 18952.5 20847.7 22932.5Operating Profit 2241.0 2123.5 2017.4 2353.6 2750.8 3203.8 3720.0 4307.4 4738.1 5211.9 5733.1Interest 269.0 269.0 269.0 269.0 269.0 269.0 269.0 269.0 269.0 269.0 269.0Profit before tax 1972.0 1854.5 1748.4 2084.6 2481.8 2934.8 3451.0 4038.4 4469.1 4942.9 5464.1Tax 420.0 370.9 349.7 416.9 372.3 440.2 517.7 605.8 670.4 741.4 819.6Profit after tax 1552.0 1483.6 1398.7 1667.7 2109.5 2494.6 2933.4 3432.6 3798.7 4201.5 4644.5Fixed assets 21472.0 17696.2 14009.5 13239.0 14562.9 16019.2 17621.1 19383.2 21321.5 23453.7 25799.0Working Capital 2586.0 2949.4 2801.9 2942.0 3236.2 3559.8 3915.8 4307.4 4738.1 5211.9 5733.1+ Depreciation 608.0 530.9 420.3 397.2 436.9 480.6 528.6 581.5 639.6 703.6 774.0‐ Investment in fixed assets 256.0 ‐3775.8 ‐3686.7 ‐770.5 1323.9 1456.3 1601.9 1762.1 1938.3 2132.2 2345.4‐ Investment in working capital ‐579.0 363.4 ‐147.5 140.1 294.2 323.6 356.0 391.6 430.7 473.8 521.2

Free cash flow 2483.0 5426.9 5653.2 2695.3 928.3 1195.3 1504.1 1860.4 2069.3 2299.1 2551.9


Notes: More modest sales growth & Less of a decline in fixed assets per sale


Forecast 3:

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Year 1 2 3 4 5 6 7 8 9 102013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023

Turnover 15523.0 14746.9 14009.5 14710.0 16181.0 18608.1 21399.3 25679.2 30815.1 36978.1 44373.7Cost of sales + Operating costs 13282.0 12623.3 11992.1 12356.4 13430.2 15258.7 17333.5 20543.4 24652.0 29582.5 35498.9Operating Profit 2241.0 2123.5 2017.4 2353.6 2750.8 3349.5 4065.9 5135.8 6163.0 7395.6 8874.7Interest 269.0 269.0 269.0 269.0 269.0 269.0 269.0 269.0 269.0 269.0 269.0Profit before tax 1972.0 1854.5 1748.4 2084.6 2481.8 3080.5 3796.9 4866.8 5894.0 7126.6 8605.7Tax 420.0 370.9 349.7 416.9 372.3 462.1 569.5 730.0 884.1 1069.0 1290.9Profit after tax 1552.0 1483.6 1398.7 1667.7 2109.5 2618.4 3227.3 4136.8 5009.9 6057.6 7314.9Fixed assets 21472.0 17696.2 14009.5 13239.0 14562.9 16747.3 19259.4 23111.3 27733.6 33280.3 39936.3Working Capital 2586.0 2949.4 2801.9 2942.0 3236.2 3721.6 4279.9 5135.8 6163.0 7395.6 8874.7+ Depreciation 608.0 530.9 420.3 397.2 436.9 502.4 577.8 693.3 832.0 998.4 1198.1‐ Investment in fixed assets 256.0 ‐3775.8 ‐3686.7 ‐770.5 1323.9 2184.4 2512.1 3851.9 4622.3 5546.7 6656.1‐ Investment in working capital ‐579.0 363.4 ‐147.5 140.1 294.2 485.4 558.2 856.0 1027.2 1232.6 1479.1

Free cash flow 2483.0 5426.9 5653.2 2695.3 928.3 451.0 734.8 122.3 192.5 276.7 377.8


Notes: Aggressive sales growth & Less of a decline in fixed assets per sale


Forecast 4:

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4.0 WACC CalculationNow that we have the forecasted cash flows, we seek to understand what they are worth when discounted to present values. To do this we shall employ the Weighted Average Cost of Capital (WACC) calculation.

The calculation states that:

Where:rd = Debt rateTc = Tax rateD = Pfizer’s debt valueE = Pfizer’s equity valueV = Total value of Pfizer = D+Ere = Equity rate

We shall now derive each of these figures for the calculation.

rWACC = d x (1 – T )c x DV + (r x )e

EV

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Figure 4.0: WACC calculation

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4.1 Debt RatePfizer is a US based company with a sound history and strong credit rating and as such operates on the bond market. On 24th October 2014 Pfizer bonds were trading as per figure 4.1 (directly reproduced from Morningstar, 2014) . As the chart shows, Pfizer have 2 bonds with 25 years to run (highlighted in red), which are trading at 5.2% and 4.29%. Taking the average of these two provides a debt rate of 4.75%. This will be used for the WACC calculation.

17Figure 4.1: Pfizer bond market summary (Morningstar, 2014)

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4.2 Tax RateTo calculate Pfizer’s tax rate, the annual report accounting figures for the past 3 years were used (Pfizer, 2014b), and an average taken. These can be seen in the table below, and gives a tax rate of 26.23%

Figures in mil. US$ 2011 2012 2013 3 yr averageNet Income Before Taxes 11,481 11,242 15,716Provision for Income Taxes 3,621 2,221 4,306Net Income After Taxes 7,860 9,021 11,410Tax Rate 31.54% 19.76% 27.40% 26.23%

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Table 4.2: Pfizer historic tax payments and rates 2011 – 2013 (Pfizer, 2014b)

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4.3 Debt / Value and Equity / Value SplitTo calculate the firm’s debt/equity split, one approach would have been to use the figures published in Pfizer’s 2013 annual report. However, these figures have been modified by well‐paid accountants whose job it is to value the firm as highly as possible. It could also be argued that a firm is only valued at what people are willing to pay for it, and it is for these two reasons that we shall use the market value to value Pfizer.

On 27th May 2014, the adjusted close of Pfizer shares was $29.35. The 2013 annual report states that there were 6.34 billion shares outstanding, giving a market capitalisation of $186bn. With total long term debt quoted as £30.46bn, this gives a Debt/Value ratio of 16.38%, and therefore an Equity/Value ratio of 83.62%.

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4.41 Equity Rate calculation, risk free rate and EMRPTo calculate the expected return on equity, we shall use the Capital asset pricing model (CAPM), which is as follows:

Where:rf= Risk free rate β = Beta rm = Market rate (the expected return on a diversified market portfolio)

CAPM states that (rm – rf) can also be called the ‘Market risk premium’, and in this respect it is the Equity Market Risk Premium (EMRP), and so we can rephrase the equation as:

For the risk free rate, we will use a risk free government bond ( 30 year Treasury bond) which had a rate on 27thMay 2014 (26th May was a public holiday in USA) of 3.37%.

There is great academic debate over what is the best method for calculating EMRP; often just deciding whether to use an ex‐post or ex‐ante approach causes vast discussion (Ogier et al, 2004, p64). For this calculation a figure of 5.2% has been chosen which represents an arithmetic mean of equity prima over T‐bonds from 1962‐1997 (Ogier et al, 2004, p71).

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Figure 4.41a: CAPM calculation

Figure 4.41b: CAPM calculation substituting in EMRP

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4.42 BetaThe Beta for Pfizer was calculated using weekly returns for a period from 1st Jan 2012 to 1st Oct 2014 against S&P 500 returns over the same period (Data sourced from Yahoo Finance). Weekly returns were chosen as they are less ‘noisy’ than daily returns. There are also a number of published Beta figures available from various outlets. These are listed below along with the calculated Beta.

As the table shows, the calculated beta is in a similar ‘ballpark’ to the published betas.

Calculated beta Yahoo finance FT Reuters

Pfizer 0.78 0.72 0.7114 0.71

y = 0.7751x + 0.0006R² = 0.2729

‐0.08

‐0.06

‐0.04

‐0.02

0

0.02

0.04

0.06

0.08

‐0.05 ‐0.04 ‐0.03 ‐0.02 ‐0.01 0 0.01 0.02 0.03 0.04 0.05 0.06Pfizer re

turn

Market return

Weekly returns: Pfizer v’s Market To the left is a scatter plot of the figures used in the calculated beta showing an R² figure of .27, suggesting that only 27% of the total risk is down to market movement and therefore 73% is idiosyncratic risk.

21Figure 4.42: Scatter plot showing weekly returns of Pfizer against the Market Jan 2012 – Oct 2014 (Yahoo finance, 2014)

Table 4.42: Beta figures for Pfizer (Yahoo finance, 2014; FT.com, 2014; Reuters.com, 2014)

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4.5 Calculated WACCThe preceding figures allow a calculated return on equity as follows:

Using this return on equity rate and all of the figures calculated previously, this allowed a calculation of WACC as follows:

This provides an after tax WACC for Pfizer of 6.78%.

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=risk free rate

+ Beta EMRP

= 0.0337 + 0.78 0.052

re = 0.07426

= Debt rate x (1‐ tax rate) xDebt / Value

+ (re xEquity / Value)

= 0.0475 x 1‐ 0.2623 x 0.1638 + 0.07426 x 0.8362

WACC = 0.06784

Figure 4.51: Equity return calculation

Figure 4.52: WACC calculation

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4.61 Industry BetaIt is acknowledged that individual company beta calculations are susceptible to a large margin of error (Brealey et al, 2014). Therefore, having calculated a WACC based on Pfizer’s beta, it is advisable to calculate a WACC based on an industry beta.

The industry analysis has been completed using data as detailed in the table below:

Using these six companies allows an industry beta to be calculated (using the arithmetic mean).

This gives a figure of 0.72 (which is actually quite close to Pfizer’s figure).

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Pfizer AstraZeneca GSK Novartis Merck & Co Roche Average

Beta 0.778 0.754 0.606 0.654 0.539 0.993 0.721

Table 4.42: Beta figures for Industry firms (Data from Yahoo Finance, range ‐ Jan 2012 – Oct 2014)

Pfizer AstraZeneca Novartis Merck & Co GlaxoSmithKline RocheJohnson & Johnson

AbbVie

Country USA UK USA USA UK SwitzerlandDiscounted due to a large ‘FMCG’ offering

Discounted due to their recent (Jan 2013) formation coming from a split from their parent company Abbott Laboratories thus limiting data available

Traded on NYSE LSE NYSE NYSE LSE Swiss Exchange

Market index for Beta

S&P 500 FTSE 350 S&P 500 S&P 500 FTSE 350SMI (top 20

firms)

2013 Revenue ($ billion)

51.6 25.7 57.9 48.0 41.2 49.2

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4.62 Industry WACCUsing this industry beta a new Return on Equity figure can be calculated an associated revised WACC can be derived:

The industry beta provides a new WACC figure for Pfizer of 6.52%.

24

=risk free rate

+ Beta EMRP

= 0.0337 + 0.72 0.052

re = 0.07114

Figure 4.62a: Equity return calculation

Figure 4.62b: WACC calculation

= Debt rate x (1‐ tax rate) xDebt / Value

+ (re xEquity / Value)

= 0.0475 x 1‐ 0.2623 x 0.1638 + 0.07114 x 0.8362

WACC = 0.06523

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5.1 Discounted Cash flowsThe calculated WACC of 6.52% can now be applied to the free cash forecasts to discount them back to the present value. The cash flow for the first 9 years will be used, and the four forecasts are shown in the following tables below:

Forecast 1: Aggressive sales growth & Large declines in fixed assets per sale

25

Historic Free Cash Flows (£m)

1 2 3 4 5 6 7 8 9 Total2014 2015 2016 2017 2018 2019 2020 2021 2022

Free cash flow 5426.9 5653.2 2695.3 2497.8 2442.8 1164.6 3315.1 1455.9 5379.7

Present value 5094.6 4982.0 2229.9 1940.0 1781.1 797.1 2130.1 878.2 3046.3 22879.4

Forecast 2: More modest sales growth & Large declines in fixed assets per sale


1 2 3 4 5 6 7 8 9 Total2014 2015 2016 2017 2018 2019 2020 2021 2022

Free cash flow 5426.9 5653.2 2695.3 2497.8 3030.2 1742.6 4211.9 2502.2 5303.1

Present value 5094.6 4982.0 2229.9 1940.0 2209.3 1192.7 2706.3 1509.3 3003.0 24867.2

Table 5.11: Free cash flow forecasts for option 1


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5.1 Discounted Cash flowsForecast 3: More modest sales growth & Less of a decline in fixed assets per sale

26

Forecast 4: Aggressive sales growth & Less of a decline in fixed assets per sale


1 2 3 4 5 6 7 8 9 Total2014 2015 2016 2017 2018 2019 2020 2021 2022

Free cash flow 5426.9 5653.2 2695.3 928.29 1195.3 1504.1 1860.4 2069.3 2299.1

Present value 5094.6 4982.0 2229.9 721.0 871.5 1029.5 1195.4 1248.2 1301.9 18674.0


1 2 3 4 5 6 7 8 9 Total2014 2015 2016 2017 2018 2019 2020 2021 2022

Free cash flow 5426.9 5653.2 2695.3 928.29 450.95 734.79 122.3 192.49 276.72

Present value 5094.6 4982.0 2229.9 721.0 328.8 502.9 78.6 116.1 156.7 14210.6



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5.2 Horizon ValueThe final task is to calculate a horizon value for AstraZeneca. Taking into account the fact that it takes a number of years to get a drug to market, it is fair to assume that AstraZeneca’s poor results over the past 2 years, and their poor growth forecasts, that their 10 year+ pipeline may not be as strong as their mid‐term pipeline, and therefore growth is likely to level off to a long‐run rate of 5%.

This figure will be used in the constant‐growth DCF formula to calculate a horizon value from year 10 onwards. Again, the four forecasts have been used, with the results shown below:

27

Table 5.2: Calculated horizon valuations

Forecast No.

Forecast detailValuation at Horizon (£m)

Discounted Valuation (£m)

1 Aggressive sales growth & Large declines in fixed assets per sale

97876 55424

2 More modest sales growth & Large declines in fixed assets per sale

113473 64256

3 More modest sales growth & Less of a decline in fixed assets per sale

89091 50449

4 Aggressive sales growth & Less of a decline in fixed assets per sale

13189 7469

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6.0 Discounted ValuationsTo calculate the final valuations for AstraZeneca the discounted cash flows just need to be added to the horizon values. A summary showing the four forecasted values and the final offer made by Pfizer is shown below:

Forecast Present Value Notes1 £78.3bn Aggressive sales growth & Large declines in fixed assets per sale2 £89.1bn More modest sales growth & Large declines in fixed assets per sale3 £69.1bn More modest sales growth & Less of a decline in fixed assets per sale4 £21.7bn Aggressive sales growth & Less of a decline in fixed assets per saleOffer £69.4bn Value of Pfizer's highest offer

The discounted valuations are also shown to the right in graphical form, along with the highest offer made by Pfizer.

£‐

£10,000

£20,000

£30,000

£40,000

£50,000

£60,000

£70,000

£80,000

£90,000

£100,000

1 2 3 4 Offer

Value £m

Forecast

Discounted Valuations and offer made

Table 6.0: Discounted valuations for AstraZeneca in comparison to Pfizer’s offer

Figure 6.0: Discounted valuations for AstraZeneca in comparison to Pfizer’s offer

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7.0 The tax havenIn addition to the cash flows generated by AstraZeneca, it is also worth appreciating what the UK tax haven is worth to Pfizer. The table below shows the tax figures from the past 3 years that Pfizer has paid (Pfizer, 2013):

To understand the potential saving, we must understand how much of Pfizer’s profits are generated in the USA. According to Global Company Intelligence (2014a), in 2013 Pfizer generated 39.2% of its revenues in the USA. Taking this figure it can be estimated that for 60.8% of revenues, Pfizer could enjoy a tax rate of 20% (we shall not complicate the issue further with the patent box rate of 10% due in 2017). These basic calculations show that over the past 3 years, Pfizer would have averaged $499m more profits per year if it had enjoyed this tax haven.

2011 2012 2013 3 yr averageNet Income Before Taxes 11,481.0 11,242.0 15,716.0 2,813.0 Provision for Income Taxes 3,621.0 2,221.0 4,306.0 3,382.7 Net Income After Taxes 7,860.0 9,021.0 11,410.0 9,430.3 Tax Rate 31.54% 19.76% 27.40% 26.23%

2011 2012 2013 3 yr averageHistoric Provision for Income Taxes 3,621.0 2,221.0 4,306.0 3,382.7Tax on 39.2% at existing rate 1419.432 870.632 1687.952 1,326.0Tax haven rate on 60.8% of income 1396.09 1367.027 1911.066 1,558.1Revised Tax provision 2815.522 2237.659 3599.018 2,884.1Saving 805.5 ‐16.7 707.0 498.6

Table 7.01: Pfizer taxes paid and tax rates 2011 – 2013 (Pfizer, 2013)

Table 7.02: Calculated tax savings from Pfizer using the tax haven

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8.0 ConclusionQuestion 1: Was the AstraZeneca board right to reject the final offer of £55/share offered by Pfizer?

As table 6.0 shows, Pfizer’s maximum offer for AstraZeneca fell short of two of the company valuations by £8.9bn (forecast 1) and £19.7bn (forecast 2), suggesting that the offer undervalued AstraZeneca, and the board were correct to reject. However, both of these valuations were calculated using sales projections based on the revised strategy provided by AstraZeneca during the negotiations with a revenue target of £45bn. To hit this target requires aggressive growth that is in stark contrast to short term predictions of slight negative growth.

Forecast 4 provides an interesting valuation that should be discounted as it would never be considered a viable strategy. It suggests that to target the sales growth without the associated cutting of fixed asset spending would result in poor free cash flows and so should not be considered by management.

Forecast 3 values AstraZeneca at a figure £0.3bn below the AstraZeneca offer. As the valuation with the most modest sales growth and fixed asset cost reduction, it could be considered the ‘conservative forecast’ and therefore the most realistic as a post‐acquisition forecast. Taking this into account, this report concludes that the offer made by Pfizer was a fair price and the board were wrong to reject the advance.

Question 2: Now that the regulatory cooling off period has elapsed, should Pfizer attempt an acquisition again, offering a higher price?

With regards to whether Pfizer should increase their offer now the cooling off period has passed, this is where the tax haven comes into play. In addition to the discounted cash flows and horizon valuation, Pfizer would also have benefited from the tax haven aspect. Historic data suggests that benefit to be substantial and therefore Pfizer could afford to pay (and therefore offer) more if that tax haven could be used.

However, since the initial offer there have been moves by the US government to close this option off to companies, as demonstrated by the recent collapse of another US‐UK takeover, that of AbbVie on Shire (FT, 2014d).

It is for the reasons listed above that this report does not recommend an increased offer in the future.

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9.0 Recommended further WorkAlthough not possible in the scope of this report, a number of further areas of analysis are recommended, mainly focusing on the impact of the tax haven:

1) If the two companies were to merge, a new debt/equity profile would probably be created as the deal would likely include borrowing, spending cash and changes to share structure. Because of this reason the development of more detailed debt/value and equity/value figures for the proposed new company and structure would allow a new WACC to be calculated that may be more representative.

2) In addition to 1, it may be interesting to calculate a new WACC taking into account the new tax rates from the tax haven

3) Finally, it is felt that it would be of benefit to forecast two sets of free cash flow figures for Pfizer. An as‐is forecast, and then a second forecast that takes into account the impact on cash flows of the tax haven.

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10.0 ReferencesAstraZeneca, 2014a. Pioneering science, life-changing medicines , AstraZeneca Annual Report, London: AstraZeneca PLC

AstraZeneca, 2014b. AstraZeneca updates on the rapid progress of its oncology pipeline at ASCO 2014. [Press Release] 3 June 2014. Available at: http://www.astrazeneca.com/Media/Press-releases/Article/20140603--AstraZeneca-updates-on-the-rapid-progress-of-oncology-pipeline-at-ASCO-2014 [Accessed 26 October 2014]

BBC, 2014a. The Cadbury deal: How it changed takeovers. BBC [online] 2 May 2014. Available at: http://www.bbc.co.uk/news/business-27258143[Accessed 26 October 2014]

Brealey, R., Myers, S. and Allen, F., 2014. Principles of Corporate Finance, 11th Edition, Maidenhead: McGraw-Hill Education

FT.com, 2014a. Pfizer admits defeat in AstraZeneca bid, Financial Times Online [Online] 26 May 2014. Available at: http://www.ft.com/cms/s/0/418ce3cc-e4b7-11e3-9b2b-00144feabdc0.html#axzz3G91q7000 [Accessed 26 October 2014]

FT.com, 2014b. AstraZeneca Plc, Financial Times Online [Online] 20 October 2014. Available at: http://markets.ft.com/research/Markets/Tearsheets/Forecasts?s=AZN:LSE [Accessed 20 October 2014]

FT.com, 2014c. AstraZeneca steps up defence with long-term revenue forecast, Financial Times Online [Online] 06 May 2014. Available at: http://www.ft.com/cms/s/0/7600097e-d501-11e3-adec-00144feabdc0.html#slide0 [Accessed 26 October 2014]

FT.com, 2014d. AbbVie hits at Treasury as Shire deal dies, Financial Times Online [Online] 20 October 2014. Available at: http://www.ft.com/cms/s/0/0c347b86-58a2-11e4-a31b-00144feab7de.html?siteedition=uk#axzz3HFZ2VZNP [Accessed 26 October 2014]

Global Company Intelligence , 2014a. Pfizer Inc, Available at: http://www.globalcompanyintelligence.com/CompanyView.aspx?Type=Company Home&CID=32190 [Accessed 26th

October 2014]

Global Company Intelligence , 2014b. AstraZeneca Plc, Available at: http://www.globalcompanyintelligence.com/CompanyView.aspx?Type=Company Home&CID=3904 [Accessed 26th

October 2014]

Guardian, 2014a. Pfizer's battle to buy AstraZeneca – timeline, The Guardian online [Online] 20 May 2014. Available at: http://www.theguardian.com/business/2014/may/14/pfizer-takeover-approach-astrazeneca-timeline [Accessed 26 October 2014]

Guardian, 2014b. Pfizer's AstraZeneca takeover would give US firm substantial tax benefits, The Guardian online [Online] 28 April 2014. Available at:http://www.theguardian.com/business/2014/apr/28/pfizer-astrazeneca-takeover-tax-benefits [Accessed 26 October 2014]

Monringstar, 2014. Pfizer Ins: Yield to Maturity [online]. Available at: http://quicktake.morningstar.com/stocknet/bonds.aspx?symbol=pfe [Accessed 26 October 2014]

Ogier, T. Rugman, J. and Spicer, L., 2004, The Real Cost of Capital: A Business Field Guide to Better Financial Decisions, Harlow: Pearson Education

Pfizer, 2014a. STATEMENT FROM PFIZER INC.: PFIZER MAKES FINAL PROPOSAL TO ASTRAZENECA [Company Filing: pdf] 18th May 2014 Available at: http://s.portalworks.thomsonib.com/thomsonsolutions/Report.aspx?reportType=Filings-DCN&companyId=cr03369774|cr03351862|cr03352128|cr03405806|cr03369310&companyKey=default&PRODUCT_CODE=Banker&TFN_THEME=Blue [Accessed on 26th October 2014]

Pfizer, 2014b. Annual Review 2013, New York: Pfizer Inc

Pfizer, 2014c. STATEMENT FROM PFIZER INC.: POSSIBLE OFFER FOR ASTRAZENECA PLC [Company Filing: pdf] 2nd May 2014 Available at: http://s.portalworks.thomsonib.com/thomsonsolutions/Report.aspx?reportType=Filings-DCN&companyId=cr03369774|cr03351862|cr03352128|cr03405806|cr03369310&companyKey=default&PRODUCT_CODE=Banker&TFN_THEME=Blue [Accessed on 26th October 2014]

PWC, 2014. Global Top 100 Companies by market capitalisation [Online] 31st March 2014 Available at: Market Cap data source http://www.pwc.com/gx/en/audit-services/capital-market/publications/assets/document/pwc-global-top-100-march-update.pdf [Accessed on 26th October 2014]

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