AProject Report

On“CAPITAL BUDGETING”

At

DR. REDDY’S LABORATORIES LIMITED

Dissertation Submitted

In The Partial Fulfillment for the Award of the Degree

In Finance

Submitted By

Under the guidance of

FinanceManager

At Dr. Reddy’s, FTO-III, Bachupally

CERTIFICATE

This is to certify that the Project Work entitled “CAPITAL BUDGETING” at

Dr. Reddy’s, FTO – III, Bachupally , is a bonafied work of

submitted in partial fulfillment of the requirements for the award of the degree of

“Masters Programme In International Business” for the academic year

Mr. T. Koteshwar Rao

(Internal Project Guide) (External Examination) (Department of Management

Studies)

DECLARATION

I hereby declare that the project report titled “CAPITAL BUDGETING” submitted in

partial fulfillment of the requirements for the Post Graduation of “Masters Programme In

International Business”, from a bonafide work carried out by me under the guidance of

Mr. T. Koteshwar Rao, Managing Director of Finance, Dr. Reddy’s Laboratories Limited,

FTO – III, Bachupally Hyderabad.

I also declare that this is the result of my own effort and is not submitted to any other

University for the award of any other Degree, Diploma, Fellowship or prizes.

Place:

ACKNOWLEDGEMENT

I take this opportunity to acknowledge, all the people who rendered their valuable advice in

bringing the project to function.

As part of curriculum at college. The project enables us to enhance our skills, expand our

knowledge by applying various theories, concepts and laws to real life scenario which

would further prepare us to face the extremely “Competitive Corporate World” in the near

future.

I express my sincere gratitude to the staff of COLLEGE Hyderabad. I specially thank “the

management and staff of Dr. Reddy’s” for creating out the study and for their guidance and

encouragement that made the project very effective and easy.

I sincerely express my gratitude to Mr. Koteshwar Rao, Finance, Manager

Dr. Reddy’s, for his valuable guidance and cooperation throughout my project work.

I would like to thank Mr. Koteshwar Rao, Mr. Kalyan Kumar and Mr. Doki Srinivas ,

for guiding and directing me in the process of making this project report and for all the

support and encouragement.

I am grateful to our Internal Faculty, faculty in MPIB Department for his support and

assistance in my project work.

I have tried my level best to put my experience and analysis in writing this report. I am

grateful to Dr. Reddy’s as an organization and its various employees for helping me to learn

and explore many fields.

INDEX

I. Introduction Page No.

Definition of Capital Budgeting

Scope of the study

Objective of the study

Need for the study

Limitations of the study

Methodology

II. Industry Profile

History of the Pharmaceuticals Industry

Major players of the World Pharmaceuticals Industry

The Indian Pharmaceuticals Industry

III. Company Profile

About the Company

Board of Directors

Strategic Business Units

Key Milestones

Department

IV. Capital Budgeting

V. Findings and Suggestions

VI. Bibliography

INTRODUCTION

Definition of Capital Budgeting

Capital budgeting (or investment appraisal) is the planning process used to determine

whether a firm's long term investments such as new machinery, replacement machinery,

new plants, new products, and research development projects are worth pursuing. It is

budget for major capital, or investment, expenditures

NEED and IMPORTANCE FOR CAPITAL BUDGETING

Capital budgeting means planning for capital assets. The importance of capital budgeting

can be well understood from the fact that an unsound investment decision may prove fatal to

the very existence of the concern. The need, significance or importance of capital budgeting

arises mainly due to the following:

1. Large Investments: Capital budgeting decisions involves large investment of funds but

the funds available with the firm are always limited and demand for funds far exceeds

the resources. Hence, it is very important for the firm to plan and control its capital

expenditure.

2. Long – Term Commitment of Funds: It increases the financial risk involved in the

investment decision.

3. Irreversible Nature: The capital expenditure decisions are of irreversible in nature .

Once the decision for acquiring a permanent asset is taken, it becomes very difficult to

dispose of these assets without incurring heavy losses.

4. Long – Term Effect on Profitability: Capital budgeting decisions have a long - term

and significant effect on the profitability of a concern. Not only are the present earnings

of the firm affected by the investments in capital assets.

5. Difficulties of Investment Decision: The long term investment decisions are difficult to

be taken because decision extends to a series of years beyond the current accounting

period.

SCOPE OF THE STUDY

The study is done on capital budgeting held by Generics division of Dr. Reddy’s

Laboratories Limited.

The scope of the study includes the Payback period method.

OBJECTIVES OF THE STUDY

Main Objective: -

The main Objective of the project is to understand why Payback period is better than other capital budgeting techniques from the company’s point of view.

Sub – Objectives: -

To know the investment criteria done by Dr. Reddy’s lab while evaluating a project.

a) To study the financial feasibility of the proposal.

b) To find out the benefits that the company is going to get from the new projects.

c) To critically evaluate a project using different types of capital budgeting techniques. and to arrive at the right conclusion.

d) To understand advantages and disadvantages of various techniques.

e) Estimating of assets & tools required for this new project.

NEED FOR THE STUDY

Capital budgeting means planning for capital assets. The need of capital budgeting can be

well understood from the fact that an unsound investment decision may prove fatal to the

very existence of the concern. It is used to determine whether Dr. Reddy’s long term

investments such as new machinery, replacement machinery, new plants, new products, and

research development projects are worth pursuing. It is budget for major capital, or

investment, expenditures.

LIMITATIONS OF THE STUDY

Since the study covers only Generics division of Dr. Reddy’s Laboratories Limited,

it does not represent the overall scenario of the industry.

Few values taken are on facts basis.

The project is constraint to only one proposal.

This is a study conducted within a period of 45 days.

During this limited period of study, the study may not be a detailed, fully

fledged and utilitarian one in all aspects.

The study contains some assumption based on the demands of the analysis

done by the company executives.

INDUSTRY

PROFILE

PROFILE OF THE INDUSTRY

History of the pharmaceutical industry

The earliest drugstores date back to the middle Ages. The first known drugstore was

opened by Arabian pharmacists in Baghdad in 755 A.D., and many more soon began

operating throughout the medieval Islamic world and eventually medieval Europe. By the

19th century, many of the drug stores in Europe and North America had eventually

developed into larger pharmaceutical companies.

Most of today's major pharmaceutical companies were founded in the late 19th and

early 20th centuries. Key discoveries of the 1920s and 1930s, such as insulin and penicillin,

became mass-manufactured and distributed. Switzerland, Germany and Italy had

particularly strong industries, with the UK, US, Belgium and the Netherlands following suit.

Cancer drugs were a feature of the 1970s. From 1978, India took over as the primary

center of pharmaceutical production without patent protection

The pharmaceutical industry entered the 1980s pressured by economics and a host of

new regulations, both safety and environmental, but also transformed by new DNA

chemistries and new technologies for analysis and computation. Drugs for heart disease and

for AIDS were a feature of the 1980s, involving challenges to regulatory bodies and a faster

approval process.

Diagram 1: The Core of Pharmaceutical Business

(source: )

THE INDIAN PHARMACEUTICAL INDUSTRY

“The Indian pharmaceutical industry is a success story providing employment for

millions and ensuring that essential drugs at affordable prices are available to the vast

population of this sub-continent.”

Drug Discovery&

Development

Intermediates

API Finished Dosages

Branded Generics

The pharmaceutical industry plays a crucial role in building a country’s human

capital. In India, it is among the top science based industries with a wide range of

capabilities in the complex field of Drug Technology and Manufacture.

Achievements of the industry during the last three decades have been spectacular by

any standards, from a mere processing industry it has grown into a sophisticated sector with

advanced manufacturing technology, modern equipment and stringent quality control.

A highly organized sector, the Indian Pharmacy Industry is estimated to be worth

$ 4.5 billion, growing at about 8 to 9 percent annually. It ranks very high in the third world,

in terms of technology, quality and range of medicines manufactured. From simple

headache pills to sophisticated antibiotics and complex cardiac compounds, almost every

type of medicine is now made indigenously.

The Indian Pharmaceutical sector is highly fragmented with more than 20,000

registered units. It has expanded drastically in the last two decades. The leading 250

pharmaceutical companies control 70% of the market with market leader holding nearly 7%

of the market share. It is an extremely fragmented market with severe price competition and

government price control.

The “organized” sector of India's pharmaceutical industry consists of 250 to 300

companies, which account for 70 percent of products on the market, with the top 10 firms

representing 30 percent. However, the total sector is estimated at nearly 20,000 businesses,

some of which are extremely small approximately 75 percent of India's demand for

medicines is met by local manufacturing.

In 2008, India's top 10 pharmaceutical companies were Ranbaxy, Dr. Reddy's

Laboratories, Cipla, Sun Pharma Industries, Lupin Labs, Aurobindo Pharma,

GlaxoSmithKline Pharma, Cadila Healthcare, Aventis Pharma and Ipca Laboratories

Indian-owned firms currently account for 70 percent of the domestic market, up from less

than 20 percent in1970. In 2008, nine of the top 10 companies in India were domestically

owned, compared with just four in 1994.

Rank Company Revenue 2008

(Rs in crore)

1 Ranbaxy Laboratories Rs. 25,196.48

2 Dr. Reddy’s Laboratories Rs. 4,162.25

3 Cipla Rs, 3,763.72

4 Sun Pharma Industries Rs. 2,463.59

5 Lupin Laboratories Rs. 2.215,52

6 Aurobindo Pharma Rs. 2,080.19

7 Glaxo SmithKline Pharma Rs. 1,773.41

8 Cadila Healthcare Rs. 1,613.00

9 Aventis Pharma Rs. 983.80

10 Ipca Laboratories Rs. 980.44

Source: http://specials.rediff.com/money/2008/jun/11sld01.htm

Table 1:

Top 10 Indian Pharmaceuticals Companies, 2008

India's potential to further boost its already-leading role in global generics

production, as well as an offshore location of choice for multinational drug manufacturers

seeking to curb the increasing costs of their manufacturing, R&D and other support

services, presents an opportunity worth an estimated $48 billion in 2008.

India's US$ 3.1 billion pharmaceutical industry is growing at the rate of 14 percent

per year. It is one of the largest and most advanced among the developing countries. Over

20,000 registered pharmaceutical manufacturers exist in the country.

Indian Pharmaceutical Evolution

Over-the-Counter Medicines

The Indian market for over-the-counter medicines (OTCs) is worth about $940

million and is growing 20 percent a year, or double the rate for prescription medicines. the

government is keen to widen the availability of OTCs to outlets other than pharmacies, and

the Organization of Pharmaceutical Producers of India (OPPI) has called for them to be sold

in post offices.

Developing an innovative new drug, from discovery to worldwide marketing, now

involves investments of around $1 billion, and the global industry's profitability is under

constant attack as costs continue to rise and prices come under pressure. Pharmaceutical

production costs are almost 50 percent lower in India than in Western nations, while overall

R&D costs are about one-eighth and clinical trial expenses around one-tenth of Western

levels.

“India's largest-selling drug products are antibiotics, but the fastest growing are Diabetes,

cardiovascular and central nervous system treatments”.

Phase IIGovernment ControlIndian Patent Act –1970Drug prices cappedLocal companies begin to make an impact

Phase III Development Phase

Process development

Production infrastructure creation

Export initiatives

Phase IV

Growth Phase

Rapid expansion of domestic market

International market development

Research orientation

Phase V

Innovation and ResearchNew IP lawDiscovery Research Convergence

Phase IEarly YearsMarket share domination by foreign companiesRelative absence of organized Indian companies

The industry's exports were worth more than $3.75 billion in 2005-06 and they have

been growing at a compound annual rate of 22.7 percent over the last few years, according

to the government's draft National Pharmaceuticals Policy for 2007, published in January

2007. The Policy estimates that, by the year 2010, the industry has the potential to achieve

$22.40 billion in formulations, with bulk drug production going up from $1.79 billion to

$5.60 billion: “India's rich human capital is believed to be the strongest asset for this

knowledge-led industry. Various studies show that the scientific talent pool of 4 million

Indians is the second-largest English-speaking group worldwide, after the USA.”

VAT :

In April 2005, the government introduced value-added tax for the first time and

abolished all other taxes derived from sales of goods. So far, 22 states have implemented

VAT, which is set at 4 percent for medicines. This led to pharmaceutical wholesalers and

retailers cutting their stocks dramatically, which severely affected drug manufacturers' sales

for several months.

Opportunities

The main opportunities for the Indian pharmaceutical industry are in the areas of:

Generics (including biotechnology generics)

Biotechnology

Outsource and R&D (outsourcing).

Pricing (including contract manufacturing, information technology (IT)

COMPANY PROFILE

OVERVIEW OF DR.REDDY’S LABORATORIES LIMITED

ABOUT THE COMPANY

Dr. Reddy’s Laboratories Limited (Dr. Reddy’s) together with its subsidiaries

(collectively, the company) is a leading India- based pharmaceutical company head quarter

in Hyderabad, India. The company’s principal areas of operation are formulations, active

pharmaceutical ingredients and intermediates, generics, custom pharmaceutical services,

critical care and biotechnology and drug discovery. The company’s principal reached and

developed and manufacturing facilities are located in Andhra Pradesh, India and Cuernavaca

cuautla, Mexico with principal marketing facilities in India, Russia, United States, United

Kingdom, Brazil, and Germany. The company’s shares trade on several stock exchanges in

India and, since April 11, 2001, on the NYSE and in the US as of March 31, 2007.

Since Dr. Reddy’s Laboratories inception in 1984, it has chosen to walk the path of

discovery and innovation in health science. Dr. Reddy’s has been a quest to sustain and

improve the quality of life and Dr. Reddy’s had more than three decades of creating safe

pharmaceutical solution with the ultimate purpose of making the world a healthier place. Dr.

Reddy’s competencies cover the entire pharmaceutical value chain – API and Intermediates,

Finished Dosages (Branded and Generic) and NCE research.

Dr. Reddy’s research centre uses cutting-edge technology and has discovered

breakthrough pharmaceutical solutions in select therapeutic areas. In a short span of

operations, Dr. Reddy’s have filed for more than 75 patents. Dr. Reddy’s is the first Indian

company to out-license an NCE molecule for clinical trials. To strengthen their research

arm, it has set up a research subsidiary, Reddy US Therapeutics Inc., in Atlanta, USA

Dr. Reddy’s export API, branded formulations and generic formulations to

over 60 countries.The company exports API, branded formulations and generic

formulations to over 60 countries. The inherent strength lies in identifying relevant API and

formulations, and selling them at affordable prices across the world. A few of our API such

as Norfloxacin, Ciprofloxacin and Enrofloxacin enjoy a large customer base. The finished

dosages have an enviable track record. Some of them such as Nise, Omez, Enam, Stamlo,

Stamlo Beta, Gaiety and Ciprolet are among the top brands in India, and many have

become household names in near-regulated countries too.

The generic formulations have also become very popular in quality-conscious

regulated markets such as the US and Europe. All this has been possible because of our

innovative and sustained marketing efforts.

“The company set to spread our wings further and touch more lives across the

globe.

Dr. Reddy’s is having six manufacturing facilities (Formulations Technical

Operations Plants) across India.

Bolaram (Hyderabad) - FTOI

Bachupally (Hyderabad) – FTO II and FTO III

Yanam ( Near Kakinada) – FTO IV

Baddi (Himachal Pradesh) – FTO VI

Vishakhapatnam (Andhra Pradesh) – FTO VII

BUSINESS DIVISIONS OF DR REDDY’S LABORATORIES

Dr Reddy's is a global pharmaceutical powerhouse committed to protecting and

improving health and well-being.

The Dr. Reddy’s 5 Strategic Business Units. (SBU):

For management purposes, the Group is organized on a worldwide basis into five

strategic business units (SBUs), which are the reportable segments:

• Formulations (including Critical care and Biotechnology);

• Active Pharmaceutical Ingredients and Intermediates (API);

• Generics;

• Drug Discovery and

• Custom Pharmaceutical Services (CPS).

BOARD AND MANAGEMENT

Whole-Time Directors

Dr. Anji Reddy

Chairman

G V Prasad

Executive Vice Chairman and Chief Executive Officer

Satish Reddy

Managing Director & Chief Operating Officer

Independent & Non Whole Time Directors

Dr. Omkar Goswami

Ravi Bhoothalingam

Dr. Bruce LA Carter

Anupam Puri

Ms.Kalpana Morparia

J.P. Moreau.

The present CFO of Dr. Reddy’s is Mr. Umang Bohra

Auditors

BSR & Co. audited the financial statements of 2008 – 2009 prepared under the Indian GAAP.The Company had also appointed KPMG as independent auditors for the purpose of issuingopinion on the financial statements prepared under the US GAAP.

INERNATIONAL MARKET AREAS OF DR. REDDY’S LABORATORIES

AlbaniaBelarus Cambodia

Cayman islands China Dmpr

Ghana Guyana Haiti

Iraq Jamaica Kazakhstan

Kenya Kyrgyzstan Malaysia

Mauritius Myanmar Oman

Romania Russia Singapore

Sri Lanka St.Kitts St.lucia

Sudan Tanzania Trinidad

Uganda Ukraine Uzbekistan

Venezuela Vietnam Yemen

SHARE CAPTIAL :

(Rs in Thousands)

PARTICULARS 2004-05 2005-06 2006-2007 2007-08

Equity 479827 501114 964692 1176665

Debt-long Term 576 471085 414604 321604

Total Share Capital 480403 972199 1379296 1498269

2004 2005 2006 20070

200000

400000

600000

800000

1000000

1200000

EquityDebt

Graph 1:

Source

CURRENT FINANCIAL POSITION OF DR.REDDY’S LAB

Shareholding Pattern on May 29, 2009

Promoters Holding:No. Of Shares % of Shares

Individual Holding 4,489,484 2.66Companies 39,978,328 23.73

Sub Total 44,467,812

Indian Financial Institutions 22,524,568 13.37

Banks 312,746 0.19

Mutual Funds 10,764,293 6.39Sub Total 33,601,607 19.95

Foreign Holding:

Foreign Institutional

Investors 38,985,964 23.14

NRIs 3,097,432 1.84

ADRs / Foreign National 24,903,193 14.78Sub Total 66,986,589 39.76

Indian Public & Corporates 23,412,769 13.90Total 168,468,777 100.00

Table 3:

Source

1) 2008 - 2009, the company launched 116 new generic products, filed 110 new generic product registrations and filed 55 DMFs globally.

2) The Board of Directors of the Company have recommended a final dividend of Rs. 6.25 (125%) per equity share of Rs. 5/- face value, subject to the approval of shareholders at the ensuing Annual General Meeting.

3) Revenues in India increase to Rs. 8.5 billion ($167 million) in FY09 from Rs.8.1billions($158 million), representing a growth of 5%.

4) 36 new products launched during the year.

5) New products launched in the last 36 months contribute 14% to total revenues in FY09

Dr. Reddy’s

Extracted from the Audited Income Statement for the year ended March 31, 2009

  FY 09   FY 08    

Particulars ($) (Rs.) % ($) (Rs.) (%) Growth %

Revenues 1,365 69,441 100 983 50,006 100 39

Cost of revenues 648 32,941 47 484 24,598 49 34

Gross profit 718 36,500 53 499 25,408 51 44

Operating Expenses              

Selling, General & Administrative Expenses(a) 413 21,020 30 331 16,835 34 25

Research & Development Expenses, net 79 4,037 6 69 3,533 7 14

Write down of intangible assets 62 3,167 5 59 3,011 6 5

Write down of goodwill 213 10,856 16 2 90 0 -

Other (income)/expenses, net 5 253 0 (8) (402) (1) -

Total Operating Expenses 773 39,333 57 453 23,067 46 71

Results from operating activities (56) (2,833) (4) 46 2,341 5 -

Finance Income(b) (9) (482) (1) (31) (1,601) (3) (70)

Finance expenses(c) 33 1,668 2 21 1,080 2 54

Finance expenses, net 23 1,186 2 (10) (521) (1) -

Share of profit/ (loss) of equity accounted investees 0 24 0 0 2 0 1,100

Profit before income tax (79) (3,995) (6) 56 2,864 6 -

Income tax expense (23) (1,173) (2) 19 972 2 -

Profit for the period (102) (5,168) (7) 75 3,836 8 -

Attributable to:              

Equity holders of the company (102) (5,168) (7) 76 3,846 8 -

Minority interest 0 0 0 (0) (10) (0) -

Profit for the period (102) (5,168) (7) 75 3,836 8 -

 

Weighted average no. of shares o/s   169       169  

Diluted EPS (0.6) (30.7)     0.4 22.8  

Exchange rate   50.87       50.87  

Notes:  

(a) Includes amortization charges of Rs. 1,503 million in FY09 and Rs. 1,588 million in FY08

(b) Includes forex gain of Rs. 739 million in FY08

(c) Includes forex loss of Rs. 634 million in FY09.

(In millions)Key Balance Sheet Items

Particulars As on 31st Mar 09 As on 31st Mar 08

($) (Rs.) ($) (Rs.)

Cash and cash equivalents 110 5,603 146 7,421

Investments (current & non-current) 10 530 93 4,753

Trade and other receivables 282 14,368 134 6,823

Inventories 260 13,226 219 11,133

Property, plant and equipment 410 20,881 330 16,765

Loans and borrowings (current & non-current) 387 19,701 380 19,352

Trade accounts payable 118 5,987 107 5,427

Total Equity 827 42,045 931 47,350

Dr. Reddy’s Award and Recognition :

Best Workplaces 2008 In Biotech/ Pharma Industry Sector-The Economic Times

Best Performing CFO in the Pharma Sector for 2007

CNBC-TV18's CFO Award Saumen Chakroborty – Ex. CFO

NDTV Profit Business Leadership Awards 2007

Business Leader in the Pharmaceutical Sector

Amity Leadership Award

Best Practices in HR in Pharmaceutical Sector.

4th HR Summit '08

Dun & Bradstreet American Express

Corporate Awards 2007

Best Corporate Social Responsibility Initiative

2007 BSE – India

Pharma Excellence Awards 2006-07

Category : Corporate Social Responsibility

The Indian Express

Best Employers in India 2007 Award

Hewitt Associates & The Economic Times

South Asian Federation of Accountants (SAFA) Award 20072nd Best Annual Report in the South Asian Region

Finance Asia Achievement Awards 2006 Best India Deal - Acquisition of betapharm for $570 million

Asia-Pacific HRM Congress 2007 Global HR Excellence Award for Innovative HR Practices

And many more.

CAPITAL BUDGETING

In modern times, the efficient allocation of capital resources is a most crucial function of

financial management. This function involves organization’s decision to invest its resources

in long-term assets like land, building facilities, equipment, vehicles, etc. The future

development of a firm hinges on the capital investment projects, the replacement of existing

capital assets, and/or the decision to abandon previously accepted undertakings which turns

out to be less attractive to the organization than was originally thought, and diverting the

resources to the contemplation of new ideas and planning. For new projects such as

investment decisions of a firm fall within the definition of capital budgeting or capital

expenditure decisions.

Capital budgeting refers to long-term planning for proposed capital outlays and their

financing. Thus, it includes both rising of long-term funds as well as their utilization. It may,

thus, be defined the “firm’s formal process for acquisition and investment of capital”. To be

more precise, capital budgeting decision may be defined as “the firms’ decision to invest its

current find more efficiently in long-term activities in anticipation of an expected flow of

future benefit over a series of years.” The long-term activities are those activities which

affect firms operation beyond the one year period. Capital budgeting is a many sided

activity. It contains searching for new and more profitable investment proposals,

investigating, engineering and marketing considerations to predict the consequences of

accepting the investment and making economic analysis to determine the profit potential of

investment proposal.

The basic features of capital budgeting decisions are:

1. Current funds are exchanged for future benefits.

2. There is an investment in long term activities.

3. The future benefits will occur to the firm over series of years

Capital budgeting (or investment appraisal) is the planning process used to determine

whether a firm's long term investments such as new machinery, replacement machinery,

new plants, new products, and research development projects are worth pursuing. It is

budget for major capital, or investment, expenditures.

Capital budgeting process

The capital budget process is usually a multi-step process, including:

Identification of potential investment opportunities

Assembling of proposed investments

Inventory of Capital Assets;

Developing a Capital Investment Plan (CIP);

Developing a Multi-Year CIP;

Developing the Financing Plan; and,

Implementing the Capital Budget.

Types Of Capital Budgeting Projects:

Independent Projects - Projects unrelated to each other where a decision to accept

one project will not affect the decision to accept another

Mutually Exclusive Projects - The decision to choose only one project from the

many being considered.

Types Of Capital Budgeting Decisions:

Capital Budgeting Decision for Expansion purposes or

For replacement of existing assets.

Importance of Capital Budgeting:

Proper decision on capital budget will increase a firm’s value as well as

shareholders’ wealth

Capital budgeting is critical to a firm as it helps the firm to stay competitive as it is

expanding its business like proposing to purchase equipments to produce

additional or new products, renting or owning premises for opening new branches,

etc.

Guidelines In Capital Budgeting Analysis

As capital budgeting involves substantial initial outlay and years( at least more

than one year) to reap the benefits, it is critically important to understand some of

the cardinal principles or rules or guidelines when performing this capital

budgeting exercise.

Append below in brief pertaining to:

GUIDELINES/PRINCIPLES ON THE CAPITAL BUDGETING ANALYSIS

Guideline No1 :

Use Cash Flows And Not Accounting Profit. You need to adjust accounting profit

to arrive at the relevant cash flows .

Guideline No 2:

Focus on Incremental Cash flows. Simply it means that you should compare the

total cash flows of the company with and without the project. After determining

the incremental cash flows, you need to consider the tax implication on these

cash flows viz focus only on “after-tax incremental cash flows” in the capital

budgeting analysis.

Guideline No.3:

Consider any synergistic effect on the project. For example, when this new

product, the firm is going to introduce, will the sales of the existing products also

increase- are they complementary to each other. In financial terms, therefore we

need to consider the sales of the new products plus the increase in sales of the

existing products.

Guideline No.4:

Consider the opposite of rule no 3 re: the existing sales might reduce with the

introduction of the new products. Factored the loss of revenue from such existing

products into the capital budgeting analysis.

Guideline No.5:

Ignore sunk costs and consider only those costs which are relevant to the

projects. 

Guideline No.6:

Incorporate any NET additional working capital requirements into the capital

budgeting analysis for example the need to have additional inventories, accounts

receivables and or cash (increase in current assets) minus additional financing

from accounts payable, bank borrowings (current liabilities) .

Guideline No.7:

Excludes Interest Payments as this is already reflected in the discount rate (this

rate implicitly accounts for the cost of raising the financing).

APPRAISAL CRITERIA

A number of criteria have been evolved for evaluating the financial desirability of a

project. The important investment criteria, classified into two broad categories—non-

discounting criteria and discounting criteria—are shown in exhibit subsequent sections

describe and evaluate these criteria in some detail:

These criteria can be classifies as follows:

Comparing Methods of Valuation under Various Scenarios

Method IndependentProjects

Mutually ExclusiveProjects

*CapitalRationing *Scale Differences

IRR Acceptable Not Acceptable Not Acceptable Not AcceptableMIRR Acceptable Not Acceptable Not Acceptable Not Acceptable

Evaluation Criteria

Non- Discounting Criteria Discounting Criteria

Payback Accounting Rate Profitability Internal Net Present Annual Period of Return Index Rate of Value Capital

(ARR) (PI) Return (NPV) Charge(IRR)

NPV Acceptable Acceptable Acceptable AcceptablePayback Not Acceptable Not Acceptable Not Acceptable Not AcceptableDiscounted Not Acceptable Not Acceptable Not Acceptable Not Acceptable

Many formal methods are used in capital budgeting, including the techniques such as

Discounting Criteria

Net Present Value

Profitability Index or Benefit Cost Ratio

Internal Rate of Return

Modified Internal Rate of Return

Equivalent Annuity or Annual Capital Charge

These methods use the incremental cash flows from each potential investment, or project.

Techniques based on accounting earnings and accounting rules are sometimes used - though

economists consider this to be improper - such as the accounting rate of return, and "return

on investment."

Non-Discounting Criteria

Simplified and hybrid methods are used as well, such as

Payback Period

Discounted Payback Period

Average rate of Return

Discounting Criteria

1. Net Present Value

Each potential project's value should be estimated using a discounted cash flow (DCF)

valuation, to find its net present value (NPV). (First applied to Corporate Finance by Joel

Dean in 1951). This valuation requires estimating the size and timing of all of the

incremental cash flows from the project. These future cash flows are then discounted to

determine their present value. These present values are then summed, to get the NPV. See

also Time value of money. The NPV decision rule is to accept all positive NPV projects in

an unconstrained environment, or if projects are mutually exclusive, accept the one with the

highest NPV (GE).

The NPV is greatly affected by the discount rate, so selecting the proper rate - sometimes

called the hurdle rate - is critical to making the right decision. The hurdle rate is the

minimum acceptable return on an investment. It should reflect the riskiness of the

investment, typically measured by the volatility of cash flows, and must take into account

the financing mix. Managers may use models such as the CAPM or the APT to estimate a

discount rate appropriate for each particular project, and use the weighted average cost of

capital (WACC) to reflect the financing mix selected. A common practice in choosing a

discount rate for a project is to apply a WACC that applies to the entire firm, but a higher

discount rate may be more appropriate when a project's risk is higher than the risk of the

firm as a whole. The formula is as follows:

PV = 1

(1+r)n

Where PV = Present Value

r = rate of interest / discount rate

n = number of years

Decision Rules

A. "Capital Rationing" situation

Select projects whose NPV is positive or equivalent to zero.

Arrange in the descending order of NPVs.

Select Projects starting from the list till the capital budget allows.

B. "No capital Rationing" Situation

Select every project whose NPV >= 0

C. Mutually Exclusive Projects

Select the one with a higher NPV.

Example

Assuming that the cost of capital is 6% for a project involving a lumpsum cash outflow of

Rs.8,200 and cash inflow of Rs.2,000 per annum for 5 years, the Net Present Value

calculations are as follows:

a) Present value of cash outflows Rs.8200

b) Present value of cash inflows

Present value of an annuity of Rs.1 at 6% for 5 years=4.212

Present value of Rs.2000 annuity for 5 years = 4.212 * 2000 = Rs.8424

c) Net present value = present value of cash inflows - present value of cash outflows = 8424 -8200 = Rs.224

Since the net present value of the project is positive (Rs.224), the project is accepted.

2. Profitability Index

Profitability index identifies the relationship of investment to payoff of a proposed project.

The ratio is calculated as follows:

Profitability Index = PV of Future Cash Flow / PV of Initial Investment

Profitability Index is also known as Profit Investment Ratio, abbreviated to P.I. and Value

Investment Ratio (V.I.R.). Profitability index is a good tool for ranking projects because it

allows you to clearly identify the amount of value created per unit of investment.

A ratio of 1 is logically the lowest acceptable measure on the index. Any value lower than

one would indicate that the project's PV is less than the initial investment. As values on the

profitability index increase, so does the financial attractiveness of the proposed project.

Rules for selection or rejection of a project:

If PI > 1 then accept the project

If PI < 1 then reject the project

Decision Rule

A. "Capital Rationing" Situation

Select all projects whose profitability index is greater than or equal to 1.

Rank them in descending order of their profitability indices.

Select projects starting from the top of the list till the capital budget

B. "No Capital Rationing" Situation

Select every project whose PI >= 1.

C. Mutually Exclusive Project

Select the project with higher PI.

Example

A new machine costs Rs.8,200 and generates cash inflow (after tax)per annum of Rs.2,000 during its life of 5 years. Let us assume that the cost of capital for the company is 6%.

The present value of the cash inflows at 6% discount rate is 2000 * 4.212 = 8424. The present value of outflow is 8,200. The profitability index is (8424/8200) = 1.027.

The profitability index of 1.027 leads to an acceptance decision of the project, since it is greater than 1.

3. Internal Rate of Return

The internal rate of return (IRR) is defined as the discount rate that gives a net present

value (NPV) of zero. It is a commonly used measure of investment efficiency.

The IRR method will result in the same decision as the NPV method for (non-mutually

exclusive) projects in an unconstrained environment, in the usual cases where a negative

cash flow occurs at the start of the project, followed by all positive cash flows. In most

realistic cases, all independent projects that have an IRR higher than the hurdle rate should

be accepted. Nevertheless, for mutually exclusive projects, the decision rule of taking the

project with the highest IRR - which is often used - may select a project with a lower NPV.

One shortcoming of the IRR method is that it is commonly misunderstood to convey the

actual annual profitability of an investment. However, this is not the case because

intermediate cash flows are almost never reinvested at the project's IRR; and, therefore, the

actual rate of return is almost certainly going to be lower. Accordingly, a measure called

Modified Internal Rate of Return (MIRR) is often used.

Decision Rules

A. "Capital Rationing" Situation

Select those projects whose IRR (r) = k, where k is the cost of capital.

Arrange all the projects in the descending order of their Internal Rate of Return.

Select projects from the top till the capital budget allows.

B. "No Capital Rationing" Situation

Accept every project whose IRR (r) = k, where k is the cost of capital.

C. Mutually Exclusive Projects

Select the one with higher IRR.

Example

In the present case this is 8200 divided by 2000 = 4.1

The interest factor 4.1 for a 5 year project corresponds to a discount rate of 7%. So the IRR

of the project is 7%. An interest factor of 4.100 indicates that the present value of one Rupee

annuity for 5 years at 7% is equivalent to 4 rupees and ten paise .

The present value of Rs.2,000 annuity is 4.100 * 2000 = 8200

The present value of cash inflows = Rs.8200 and the present value of cash outflow =

Rs.8200.

At 7% the present value of cash inflows is equivale to the present value of cash outflows.

Hence 7% is the IRR of the project.

4. Modified Internal Rate of Return

MIRR is the discount rate that makes the future value of the project equal to its initial cost.

MIRR requires a reinvestment rate.

There are 3 basic steps of the MIRR:

(1) Estimate all cash flows as in IRR.

(2) Calculate the future value of all cash inflows at the last year of the project’s life.

(3) Determine the discount rate that causes the future value of all cash inflows determined in step 2, to be equal to the firm’s investment at time zero. This discount rate is known as the MIRR.

Decision rule

Take the project if MIRR is larger than the required rate.

Disadvantages

MIRR cannot rank mutually exclusive projects.

5. Equivalent Annuity Method

The equivalent annuity method expresses the NPV as an annualized cash flow by dividing it

by the present value of the annuity factor. It is often used when assessing only the costs of

specific projects that have the same cash inflows. In this form it is known as the equivalent

annual cost (EAC) method and is the cost per year of owning and operating an asset over its

entire lifespan.

It is often used when comparing investment projects of unequal lifespan. For example if

project A has an expected lifetime of 7 years, and project B has an expected lifetime of 11

years it would be improper to simply compare the net present values (NPVs) of the two

projects, unless the projects could not be repeated.

The use of the EAC method implies that the project will be replaced by an identical project.

Real Options

Real options analysis has become important since the 1970s as option pricing models have

gotten more sophisticated. The discounted cash flow methods essentially value projects as if

they were risky bonds, with the promised cash flows known. But managers will have many

choices of how to increase future cash inflows, or to decrease future cash outflows. In other

words, managers get to manage the projects - not simply accept or reject them. Real options

analyses try to value the choices - the option value - that the managers will have in the

future and adds these values to the NPV.

Ranked Projects

The real value of capital budgeting is to rank projects. Most organizations have many

projects that could potentially be financially rewarding. Once it has been determined that a

particular project has exceeded its hurdle, then it should be ranked against peer projects (e.g.

- highest Profitability index to lowest Profitability index). The highest ranking projects

should be implemented until the budgeted capital has been expended.

Non-Discounting Criteria

1. Payback Period

Payback period is the time duration required to recoup the investment committed to a

project. Business enterprises following payback period use "stipulated payback period",

which acts as a standard for screening the project. Of Technology Madras

Computation of Payback Period

When the cash inflows are uniform the formula for payback period is

Cash Outlay of the Project or Original Cost of the Asset

Annual Cash Inflow

When the cash inflows are uneven, the cumulative cash inflows are to be arrived at

and then the payback period has to be calculated through interpolation.

Here payback period is the time when cumulative cash inflows are equal to the

outflows. i.e.,

∑ Inflows = Outflows

Payback Reciprocal Rate

The payback period is stated in terms of years. This can be stated in terms of

percentage also. This is the payback reciprocal rate.

Reciprocal of payback period = [1/payback period] x 100

A. Capital Rationing Situation

Select the projects which have payback periods lower than or equivalent to the

stipulated payback period.

Arrange these selected projects in increasing order of their respective payback

periods.

Select those projects from the top of the list till the capital budget is exhausted.

Decision Rules

Mutually Exclusive Projects

In the case of two mutually exclusive projects, the one with a lower payback period is

accepted, when the respective payback periods are less than or equivalent to the stipulated

payback period.

Determination of Stipulated Payback Period

Stipulated payback period, broadly, depends on the nature of the business/industry

with respect to the product, technology used and speed at which technological

changes occur, rate of product obsolescence etc.

Stipulated payback period is, thus, determined by the management's capacity to

evaluate the environment via-a-via the enterprise's products, markets and distribution

channels and identify the ideal-business design and specify the time target.

Advantages of Payback Period

It is easy to understand and apply. The concept of recovery is familiar to every

decision-maker.

It is cost effective. It can be used even by a small firms having limited manpower

that is not trained in any other sophisticated techniques.

The payback period measures the direct relationship between annual cash inflows

from a proposal and the net investment required.

The payback period also deals with risk. The project with shorter payback period

will be usually less risky

Business enterprises facing uncertainty - both of product and technology - will

benefit by the use of payback period method since the stress in this technique is on

early recovery of investment. So enterprises facing technological obsolescence and

product obsolescence - as in electronics/computer industry - prefer payback period

method.

Liquidity requirement requires earlier cash flows. Hence, enterprises having high

liquidity requirement prefer this tool since it involves minimal waiting time for

recovery of cash outflows as the emphasis is on early recoupment of investment.

Disadvantages of Payback Period

The time value of money is ignored.

But this drawback can be set right by using the discounted payback period method.

The discounted payback period method looks at recovery of initial investment after

considering the time value of inflows.

It ignores the cash inflows received beyond the payback period. In its emphasis on

early recovery, it often rejects projects offering higher total cash inflow.

Investment decision is essentially concerned with a comparison of rate of return

promised by a project with the cost of acquiring funds required by that project.

Payback period is essentially a time concept; it does not consider the rate of return.

Example There are two projects (project a and b) available for a Company, with a life of 6

years each and requiring a capital outlay of rs.9,000/- each; and additional working

capital of rs.1000/- each.

The cash inflows comprise of profit after tax + Depreciation + Interest (Tax

adjusted) for five years and salvage value of Rs.500/- for each project plus working

capital released in the 6th year. This company has prescribed a hurdle payback

period of 3 years. Which of the two projects should be selected?

Example - Data

Project A

Cumulative Cash Inflows of Project A Project B

Cumulative Cash Inflows of Project B

Year 1 3,0003,000

2,0002,000

Year 2 3,5006,500

2,5004,500

Year 3 3,50010,000

2,5007,000

Year 4 1,50011,000

2,5009,500

Year 5 1,50013,000

3,00012,500

Year 6 3,00016,000

5,50018,000

Payback Period

3 years 4 years & 2 months

Example

• Payback period for Project A = 3 years (cumulative cash inflows = outflows)

• Payback period for Project B = 4 years + 500/3000 = 4 years and 2 months.

(Note: Interpolation technique is used here to identify the exact period at which cumulative

cash inflows will be equal to outflows. The amount required to equate is Rs.500, while the

returns from the 5th year is 3,000. Hence the addition time duration required to compute the

payback period is (500/3000) x 12 which is 2 months. The interpolation technique is used

based on the assumption that cash inflows accrue uniformly throughout the year.)

The investment decision will be to choose Project A with a payback period of 3 years and reject Project B with a payback period of 4 years and 2 months.

2. Discounted Payback Period

In investment decisions, the number of years it takes for an investment to recover its initial

cost after accounting for inflation, interest, and other matters affected by the time value of

money, in order to be worthwhile to the investor. It differs slightly from the payback period

rule, which only accounts for cash flows resulting from an investment and does not take

into account the time value of money. Each investor determines his/her own discounted

payback period rule and, as such, it is a highly subjective rule. In general, however, short-

term investors use a short number of years — or even months — for their discounted

payback period rules, while long-term investors measure their rules in years or even

decades.

3. Accounting Rate of Return

Accounting rate of return is the rate arrived at by expressing the average annual net profit

(after tax) as given in the income statement as a percentage of the total investment or

average investment. The accounting rate of return is based on accounting profits.

Accounting profits are different from the cash flows from a project and hence, in many

instances, accounting rate of return might not be used as a project evaluation decision.

Accounting rate of return does find a place in business decision making when the returns

expected are accounting profits and not merely the cash flows.

Computation of Accounting Rate of Return

The accounting rate of return using total investment.

or

Sometimes average rate of return is calculated by using the following

formula:

= Net Profit After Tax

Average Investment

Where average investment = total investment divided by 2

Decision Rules

A. Capital Rationing Situation

• Select the projects whose rates of return are higher than the cut-off rate.

• Arrange them in the declining order of their rate of return.

• Select projects starting from the top of the list till the capital available is exhausted.

B. No Capital Rationing Situation

Select all projects whose rate of return are higher than the cut-off rate.

C. Mutually Exclusive Projects

Select the one that offers highest rate of return.

Accounting Rate of Return – Advantages

It Is Easy To Calculate.

The Percentage Return Is More Familiar To The Executives.

Accounting Rate of Return – Disadvantages

The definition of cash inflows is erroneous; it takes into account profit after tax only.

It, therefore, fails to present the true return.

Definition of investment is ambiguous and fluctuating. The decision could be biased

towards a specific project, could use average investment to double the rate of return

and thereby multiply the chances of its acceptances.

Time value of money is not considered here.

Example

There are two projects (Project A and B) available for a business enterprise, with a

life of 6 years each and requiring a capital outlay of Rs.9,000/- each and additional

working capital of Rs.1000/ each. The cash inflows comprise of profit after tax +

depreciation + interest (Tax adjusted) for five years and salvage value of Rs.500/- for

each project at year 6 plus working capital released also in the 6th year.

Net Profit After Tax

Year Project A Project B

1 1,580 280

2 2,080 1,080

3 2,080 1,080

4 80 1,080

5 80 2,580

6 80 1,880

Total Net Profit After Tax 5,980 7,980

Average Annual Net Profit 5,980/6 = 996.6 7,980/6 = 1330

Taking into account the working capital released in the 6th year and salvage value of the

investment, the total investment will be (10,000- 1,500) Rs.8500 and the average investment

will be (8500/2) Rs.4250 for each project.

The rate of return calculations are:

Net profit after tax as a percentage of total investment

Project A Project B

1330 * 100 = 15.6%

8500

The investment decision will be to select Project B since its rate of return is higher than that

of Project A if they are mutually exclusive. If they are independent projects both can be

accepted if the minimum required rate of return is 11.7% or less.

Difficulties in Capital Budgeting

a) General difficulties: Ensuring that forecasts are consistent (across departments) Eliminating (reducing) conflicts of interest Reducing forecast bias: the proportion of proposed projects that have a positive NPV

is independent of the estimated opportunity cost of capital. Bottom-up and top-down planning is necessary. Control projects in progress, Post-audit afterwards Try hard to measure incremental cash flows--when you can Evaluate performance: actual versus projected; actual versus absolute standard of the

true cost of capital

b) Measurement problem:

While calculating the NPV, IRR, PAY BACK PERIOD, AND PROFITABILITY INDEX, we have to be very much careful with the calculations values throw it is a very difficult job to remember many values at a time but we have to be care full because it will effect on the total output of project in decision making.

Risk and Uncertainty:

Different capital investment proposals have different degrees of risk and uncertainly there is a slight difference between risk and uncertainty risk involves situations in which the probabilities of a particular event occurring are known where as in uncertainty these probabilities are unknown.

In many cases these two terms are used inter changeably. Risk in capital investments may be due to the general economic conditions competition, technological developments, consumer preferences etc. One to these reasons the revenues costs and economic life of a particular investment are not certain. While evaluating capital investment proposals a proper adjustment should therefore be made for risk and uncertainty

Analysis of a New Project with the help of Capital Budgeting Process.

Proposed capital: 653.1 millions

Divided in 2 phases

Phase 1 is proposed from 2009 and is assumed to be capitalized on 2011 and

Phase 2 is proposed from 2012 and is assumed to be capitalized on 2013.

- about Rs. 570.7 millions splited in 2 years for the phase 1 ( 285.37 million per year).

- about Rs. 82.4 millions in the phase 2.

With an expected rate of return of 14% starting after 2 years.

Production plant is at Baddi (Himachal Pradesh)

The project is about the producing 2 products

- Vials and

- Syringes.

The capital is divided between both the product

- Rs.578.1 millions in vials and

- Rs.75 millions in syringes.

Expecting annual average production is: 18,000,000 (from FY 11 to FY 17).

Sales and volumes are taken as per the BFROW strategic plan.

Quotations from Gland, for the following products: (Indian manufacturing charges)Liquid Vial (Zoledronic Acid) $0.75

Lypo Vial (Amifostin) $1.00

PFS (Enoxaparin Na) $0.50

Royalties will be ignored in case of development of the product.

The cost includes the purchase of assets for the production purpose and the depreciation is

on the straight line method.

Freight cost taken at 50 g per pack of 10 vials at Rs 200/per kg to US weight. SG&A costs taken in P&L as 20% on sales.

Effective Tax rate is considered at 8.8%.

First let us see if the product is given on contract then what is the cost that Dr. Reddy’s is

going to incur:

Contract Manufacturing     (Rs. Per Unit)

Type of Vial Equivalent Injection USD CC CC (In Rs) Freight Royalty

(Rs)

Non Lyophilised Zoledronic Acid – Liq 0.75 30.00 10.00

-

Lyophilised Amifostin – Lyo 1.00 40.00 10.00 -

Prefilled Syringes Enoxaparin Na 0.50 20.00 10.00

-

CC = Conversion Cost

Total cost incurred would be: Rs. 120

And if the product is manufactured at Dr. Reddy’s, then what is the cost the organization is going to incur:

Estimated in New Project (Rs. per Unit)

Type of Vial Equivalent Injection

CC Depreciation Freight Total

CC

Savings

Non Lyophilised Zoledronic Acid – Liq

5.18 - 10.00 15.18 24.82

Lyophilised Amifostin – Lyo5.18 - 10.00 15.18 34.82

Prefilled Syringes Enoxaparin Na5.18 - 10.00 15.18 14.82

Cost incurred would be: Rs. 45.54

From the above table, we can observe that if Dr. Reddy’s go for manufacturing the product

then they have a total savings of Rs.74.46.

So its beneficial for the company to go for manufacturing the product.

Liquid Lypo Pfs0

10

20

30

40

50

60

Type of Vial LL Location Equivalent Injection USD CC CC (In Rs) Frieght Royalty (Rs) Equiva-

lent Injection

Price

s

For manufacturing the product the following assets are required:

Project Cost of Non Cyto Injectables & Prefilled Syringes

(Rs. In Lakhs)Description Amount (Ph 1) Amount (Ph 2) Class of Asset       

Civil 1,112 100 BuildingsPartitions 500 - BuildingsHVAC 400 - Plant & MachEquipments 2,410 654 Plant & MachMechanical 200 - Plant & MachElectrical 270 - Electrical EquipUtility 125 30 Plant & MachValidation 70 10 Plant & MachInstruments - QC 100   Lab EquipRevenue 100 - BuildingsRevenue – QC 20 - Lab EquipConsultant Fees 150   BuildingsContingency 250 30 Plant & Mach       Total 5,707 824  

Depreciation of Non Cyto Injectables

Depreciation is calculated on Straight Line Method(Rs. In Millions)

Phase 1 Phase 2

ClassPolicy

(Life in Years)

Life AmountDep per year

Amount Dep per year

Buildings 20 to 50 35 

186.24

5.32 10.00

0.29

Plant & Mach 3 to 15 9 

345.50 38.39

72.40

8.04

Electrical Equip 5 to 15 10

  27.00

2.70

-

-

Lab Equip 5 to 15 10 

12.00

1.20 -

-

Total   570.74

47.61

82.40

8.33

Total Depreciation for the assets as per their phases:

Year FY 09 FY 10 FY 11 FY 12 FY 13 FY 14 FY 15 FY 16 FY 17 Total

Dep. in Year (Phase 1)     47.61

47.61

47.61

47.61

47.61

47.61

47.61

333.27

Dep. in Year (Phase 2)         8.33

8.33

8.33

8.33

8.33

41.65

Total Dep. ( in Mln Rs)

-

-

47.61

47.61

55.94

55.94

55.94

55.94

55.94

374.92

Conversion Cost at Manufacture is as follows:

( The Actual Total cost of the product i.e, The Cost Sheet)

Actual Material – Imported 0.07 Actual Material – India  1.53 Actual Packing – Imported  2.45 Actual Packing – India  3.57 Actual Input Taxes  0.33 Actual Landed cost 0.20Actual Subcontractor 0.00Actual Material 8.15Actual Direct Depreciation 0.94Actual Direct Manpower 0.59Actual ETF 0.08Actual HVAC 0.13Actual Maintenance 0.85Actual Other Direct 0.28Actual Other Utility 0.14Actual Power 0.08Actual Quantity 0.12Actual Steams 0.00Actual Overhead 3.21Actual Total Cost 11.36

Non Cyto Injectables Project – CC Projection

Manpower Cost Computation

 No. Of people 100 50 per shift * 2 Shifts Average salary per head 250,000Payroll Cost p.a. 25,000,000

Production 18,000,000Average annual production from fy 11 to fy 17

Manpower cost per unit 1.39

Summary of Conversion Cost

Cost Component FY 11

FY 12

FY 13

FY 14

FY 15

FY 16

FY 17

Manpower Cost 1.39 1.50 1.62 1.75 1.89 2.04 2.20

Utility cost 1.56 1.64 1.72 1.81 1.90 1.99 2.09

Depreciation 2.32 2.32 2.32 2.32 2.32 2.32 2.32

Others - - - - - - -

QC/QA 4.20 2.73 1.15 0.95 0.72 0.71 0.69

Conversion Cost (per Vial)

9.46 8.19 6.81 6.83 6.82 7.06 7.30

CC (per Vial) excl dep 7.14 5.87 4.49 4.51 4.50 4.74 4.98

Manpower Cost – 8% increment year over year

Utility Cost – 5% inflation year over year

Cost of freight per Vial

  Weight per vial Fill Liquid Weight 15 GramsBottle weight 20 GramsShippers weight 15 GramsTotal weight per vial 50 Grams     Cost per kg by air to US 200 Rs. Per kg     

Freight cost per vial 10 Rs. Per bottle

Computation of the project:

A Comparison of Capital Budgeting Techniques (Rs. in Millions)

Vial Facility - Payback period computation  Outflow Inflow Tax        

YearOutflow

Liquid Vials

Lypo Vials PFS SEZ

Net In Flow DCF @

0%Discounte

d In flow

Cum Discntd In

flow

1 260.37       -

(260.37)

1.00 (260.37)

(260.37)

2 260.37 - -   -

(260.37)

1.00 (260.37)

(520.74)

3  - -   - -

1.00 -

(520.74)

4 

143.88

2.45  

11.75

158.09

1.00 158.09

(362.65)

5 57.40

183.42

7.50  

15.93

149.46

1.00 149.46

(213.19)

6 

225.06

18.95  

26.94

270.95

1.00 270.95

57.76

7 

258.27

24.12  

33.25

315.65

1.00 315.65

373.41

8 

397.02

66.60  

53.43

517.05

1.00 517.05

890.45

9 

416.89

70.72  

28.03

515.64

1.00 515.64

1,406.09

10 

437.36

74.24  

29.35

540.95

1.00 540.95

1,947.04

Payback Period is 5 years 8 months

Pre Filled Syringes Facility - Payback period computation

Year Outflow

Rs. Mn

In flow Rs. Mn on NonLypo

In flow Rs. Mn on

Lypo

In flow

Rs. Mn on

PFS  

Net In Flow DCF

@ 0%

Discntd In flow

Cum Discntd In flow

0 25.00 (25.00) 1.00 (25.00) (25.00)1 25.00 - (25.00) 1.00 (25.00) (50.00)2 - - 1.00 - (50.00)3 1.00 1.00 1.00 1.00 (49.00)4 25.00 9.20 (15.80) 1.00 (15.80) (64.80)5 100.04 100.04 1.00 100.04 35.246 143.67 143.67 1.00 143.67 178.917 219.42 219.42 1.00 219.42 398.338 228.88 228.88 1.00 228.88 627.21

9 238.58

238.58

1.00

238.58

865.79

Payback is 5 Years 2 Months

Total Project - Payback period computation

  Outflow Inflow Tax        

Year Project Cost

Liquid Vials

Lypo Vials

PFS SEZ Net In Flow

DCF @ 0%

Discntd In flow

Cum Discntd In

flow1

285.37 - - - -

(285.37)

1.00

(285.37)

(285.37)

2 285.37

- - - - (285.37)

1.00

(285.37)

(570.74)

3   - - - - - 1.00

- (570.74)

4   143.88

2.45

1.00

11.75

159.09

1.00

159.09

(411.65)

5 82.40

183.42

7.50

9.20

15.93

133.66

1.00

133.66

(277.99)

6   225.06

18.95

100.04

26.94

370.98

1.00

370.98

93.00

7   258.27

24.12

143.67

33.25

459.32

1.00

459.32

552.31

8   397.02

66.60

219.42

53.43

736.47

1.00

736.47

1,288.78

9   416.89

70.72

228.88

28.03

744.51

1.00

744.51

2,033.30

10   437.36

74.24

238.58

29.35

779.54

1.00

779.54

2,812.83

Payback period:

The Cash Outflow is the project cost i.e., the investment done by the company.

Calculation of Inflows:

The company has made a market research and has given the estimated volumes for the

product from US, EU and RoW (Rest Of World).

And then has multiplied it with the savings of each product to get the inflows.

For example:

Volumes of US (liquid vials) : 5.8

Savings for liquid vials : 24.82

Cash inflow for liquid vials: 143.88

CC Savings - Total Project - NPV computation

Outflow

Inflows Tax

YearProject Cost

Liquid Vials

Lypo Vials PFS SEZ Net Inflows DCF @ 14%

DiscountedInflow

1 285.37 - - - - (285.37)

1.00 (285.37)

2 285.37 - - - - (285.37)

0.88 (250.32)

3 - - - - - -

0.77 -

4 -

143.88 2.45 1.00

11.75 159.09

0.67 107.38

5 82.40

183.42 7.50 9.20

15.93 133.66

0.59 79.14

6 -

225.06 18.95

100.04

26.94 370.98

0.52 192.68

7 -

258.27 24.12

143.67

33.25 459.32

0.46 209.26

8 -

397.02 66.60

219.42

53.43 736.47

0.40 294.32

9 -

416.89 70.72

228.88

28.03 744.51

0.35 261.00

10 -

437.36 74.24

238.58

29.35 779.54

0.31 239.71

NPV of the CC Savings 194.65

CC Savings - Total Project - IRR computation

  Outflow Inflows   Tax  

Year Project Cost

Liquid Vials

Lypo Vials PFS SEZ

Net In Flow DCF

Discntd In flow

1 285.37

-

-

-

-

(285.37)

1.00 (285.37)

2 285.37

-

-

-

-

(285.37)

0.75 (213.19)

3 -

-

-

-

- -

0.56 -

4 -

143.88

2.45

1.00

11.75

159.09

0.42 66.33

5 82.40

183.42

7.50

9.20

15.93

133.66

0.31 41.64

6 -

225.06

18.95

100.04

26.94

370.98

0.23 86.33

7 -

258.27

24.12

143.67

33.25

459.32

0.17 79.85

8 -

397.02

66.60

219.42

53.43

736.47

0.13 95.65

9 -

416.89

70.72

228.88

28.03

744.51

0.10 72.24

10 -

437.36

74.24

238.58

29.35

779.54

0.07 56.51

NPV of CC savings 0%

IRR of CC savings 34%

Procedure followed by Dr. Reddy’s while selecting a Project:

When a new proposal comes to Dr. Reddy’s then it goes through several important decisions

before selecting the proposal.

Let’s us assume that a proposal has come to Dr. Reddy’s

1. First the proposal goes to the Business Development team.

2. Business Development team with the help of market research team, does the necessary

market survey about the project such as

How many alternative products are already in the market?

About the product and its prices.

About its demand.

About its competitors.

which they disclose it in their annual report.

Once the project is evaluated then they decide from their organization’s point of view.

Investment required in the project.

Time of the proposal

3. Then they prepare a strategic report with all the details such as profits, cost, etc., based

on it they decide whether to manufacture the product or get it don’t on the contract basis.

4. If the product is to be manufactured then the manufacturing team decides the cost of

materials required, machines, power, buildings, etc., which help them to arrive at the

project cost.

5. Now the project comes to the finance department, where payback period, taxes,

depreciation, etc., is found out with the coordination with IPDO (Integrated Product

Development Operations) team.

6. Generally 2 years payback period is considered ideal at Dr. Reddy’s because as these are

fast moving products and chances are there that may be your competitors may go a step

ahead in producing the product.

7. Now after all the figures and facts are found out, the proposal goes to Managing

Director. Presentation is made to him with all the details which shows the pros and cons

of the proposal..

8. Then suggestions are given by the management, budget is decided and a final decision is

taken by the management whether to consider the proposal or reject it.

CONCLUSION & SUGGESTIONS

Decision and review of project

Company is getting its payback after 4 years (approximately 4.33 years) Project can be approved such that company can get back its profit with in a limited period.

Company is getting its “Discounted Pay Back” within 5.75 years even after discounting cost of capital.

NPV (Net Present Value) of the company is positive “194.65” so project the project can be approved.

PI (Profitability Index) is good because company is making money. Hence, the project can be approved.

IRR (Internal Rate of Return) is more than the cost of capital “34% so approve the project.

Decision Method Result Approve? Why?

Payback 4.33 years Yes Well, cause we get our money back

Discounted Payback

5.75 years Yes Because we get our money back, even after

discounting our cost of capital.

NPV 194.65 Yes Because NPV is positive (reject the project if NPV is negative)

Profitability Index 1.2980 Yes Cause we make money

IRR 34% Yes Because the IRR is more than the cost of capital

Dr. Reddy’s takes Payback period method only into consideration because they want their returns at the earliest as Pharmacy industry is a fasting moving industry with lot of innovative ideas year after year.

Bibliography

The information required for successful completion of the project has been collected

through primary and secondary sources.

Primary Source Data

The data has been gathered through interactions with the various officials and employees

working in the division. Some important information has been gathered through couple of

instructed interviews.

Secondary Source Data

Referred text books for collecting the information regarding the theoretical aspects of the

topic.

Financial Management - I .M Pandey

Management Accounting – R. P. Trivedi

Annual Report of Dr. Reddy’s – 2007-2008

Annual reports, magazines published by the company are used for collecting the required

information. Even help is taken from internet.

www.drreddy.com

http://money.rediff.com

http://www.pharmaceutical-drug-manufacturers.com/pharmaceutical-industry/

http://en.wikipedia.org