The Capital Asset Pricing Model - Essay Example

The formula that is used to calculate the capital asset pricing model is K = Krf + (Km – Krf)*B. The meaning of each of the variables of the capital asset pricing model is illustrated below. K = cost of capital Krf = risk-free rate Km = risk premium B = Beta coefficient   The video does not get into details as far as calculating the actual cost of capital of Pfizer, but it does point out that Pfizer has more equity than debt because the firm prefers to keep its interest payments low to maintain good liquidity and cash flows. Pfizer operates in an industry that has very high risk. Every year hundreds of new medicines project fail for a variety of reasons. Sometimes these medicines do not work as the company expected or even when they work the new drug often is not able to comply with the strict protocols to achieve FDA approval. Whenever a medicine is not able to reach the market the total costs that the pharmaceutical company incurred in becomes a sunk cost. A sunk cost can be defined as a cost that cannot be changed by any present or future decision (Weygandt, Kieso, Kimmel, 2002). Sunk costs are a major financial challenge for companies such as Pfizer. Minimizing projects that do not provide a positive stream of cash flows is imperative for the success of a company in the pharmaceutical industry.   Pfizer faces other financial challenges that are unique to its industry. For instance, the company has to invest billions of dollars each year in research and development costs. The average out-of-pocket cost to develop a new drug is $1.4 billion (Mullin, 2014). Another financial challenge Pfizer faces is that it also takes a long time for a new drug to reach the market. While a new drug is being developed the company does not obtain any inflows of cash from that project. Despite the challenges associated with developing a new drug when a company succeeds in creating a new product, the law protects firms such as Pfizer. Patent protection allows Pfizer the ability to create a monopoly market on the new drug. Patent protection in the pharmaceutical industry can last eight to ten years. During that time Pfizer would face no competition for its new drug. Another challenge that Pfizer faces is a shortage of talent in many technical fields. To recruit new talent the firm has to pay high salaries to its staff which raises the overall fixed costs of the company.  Read More