Study of Capital Structure

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STUDY OF CAPITAL STRUCTURE

Submitted to:

Table of contents

Acknowledgement 02

Certificate 03

Preface 04

Abstract 07

INTRO TO RANBAXY LABORATORIES LTD

Company Profile 08-10

Vision 10-11

Operating Joint Ventures and Subsidies 12-15

Objectives 16-18

Various divisions of Ranbaxy 19-20

Intro of Ranbaxy Plant in India and various depts. 12-23

Product Review 24-26


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INTRO TO CAPITAL STRUCTURE THEORY AND ANALYSIS

Introduction 27-28

Literature of review on Capital Structure 29

Methodology 30

Theory and Analysis 31-38

Optimal Capital Structure for Ranbaxy 39-58

Capital expenditure: an overview 59-80

Latest balance sheet and capital structure of Ranbaxy 81-82

Recommendations and Suggestions for Industry 82-90

Conclusion 91-92

Biblography 93


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ABSTRACT

A project work is a mandatory requirement for the Business Management

Programme. This type of study aims at exposing the young prospective executive to the

actual business world.

This project gives me knowledge about the capital structure and theory

analysis.Financing decisions involve raising funds for the firm. It is concerned with

formulation and designing of capital structure or leverage. The most crucial decision of

any company is involved in the formulation of its appropriate capital structure. The best

design or structure of the capital of a company helps the management to achieve its

ultimate objectives of minimising overall cost of capital, maximising profitability and also

maximising the value of the firm.

organization. It is very effective way to judge a companys cash flow prospects, as

cash is like blood life for any company.

The report initially begins with the company profile, followed by the detailed

analysis of company, like businesses of the company, products offered by the company,

financials of the company, etc

The report involves a lot of research to understand what exactly capital structure of

the company should be.thats , why companies require appropriate capital structure. The

purpose is to develop an action plan that creates such a capital structure that will

upgrades and standardize the quality of business analysis.


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INTRODUCTION TO RANBAXY

COMPANY PROFILE

A company empowered by one mission to place itself on the world map. An

enterprise propelled by one force-that synergizes its energies to charter unexplored

markets. Organizations fuelled by one dream-to transform competition into

opportunity.

Ranbaxy Laboratories Ltd. was incorporated in June 1961, in the name of M/S

LEPITIT RANBAXY LABORATORIES LTD and it commenced its business in MARCH1962, in technical and financial collaboration with an international company named

LEPTIT SPA, MILAN, ITALY.

Ranbaxy Laboratories Pvt. Ltd. merged with Leptit Ranbaxy Laboratories Pvt.

Ltd. in 1962 Ranbaxy and company also merged with this company in 1966. The

collaboration arrangement with M/S LEPTIT was terminated in 1966; after which Indian

nationals acquired the entire share capital of the company.

Therefore the word Leptit was removed from the name of the company. The name

is known as RANBAXY LABORATORIES LIMITED. In 1973 the company issued

shares to the general public and became a full fledged PUBLIC LIMITED COMPANY.

Today, Ranbaxy has emerged as a Leading

Pharmaceutical Company on the Indian firmament,

with the second largest market share and enjoys an

enviable reputation for its high standard of ethics and

quality around its core strength of anti-infective, it has

produced new brands in emerging therapeutic areas

like cardiovascular, central nervous system and

nutritional. supporting this expansion, the company has invested in world class

manufacturing infrastructure that leverages Indias comparative cost advantage and skilled

manpower, while delivering international quality.


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The companys drive for Internationalism is guided by the well planned brand

strategy that covers some of the world emerging markets like China, cis, Central Europe

and Latin America . Its position today is in league of the Top Ten Pharmaceutical

companies of three world an decent ranking as the eleventh largest company in the

international generics space is the resounding endorsement of its strategic mind.

It is clear that for a long time, the dominant share of revenues of the company

would continue to come from the ever expanding global generics market. Hence the intent

of Ranbaxy mission is to achieve a sustained growth rate through the continuous pursuit

of innovation phase one trials for pervasion, a compound for treating prosthetic males

have been completed. Phase 1 trials with clafrinast, an asthma compound is an important

step towards research based value creation.

This company also had success with Ciplofloxacine, an ingenious form, created

through the novel drug delivery systems research. As the demand of the bulk drugs inside

the country and abroad was increasingly rapidly a new, plant was set up at Toansa near

Ropar in 1987. This was a higher capacity plant designed to cater to the present and future

needs, initially antibiotics like Ampicillin, Trihydrate and Doxycycline were

manufactured.

Later, on the other drugs like Cephalexin monohydrate and Ranitidine were also

prepared. The plant at Toansa was designed to meet the stringent standards set by the Food

and Drug Administration (FDA) of U.S.A. This plant has been approved by FDA and this

will open up American and other newer markets for Ranbaxys products

At present Ranbaxy have four plants for the manufacture of bulk drugs two at Mohali, one

at Dewas (M.P) AND Another at Toansa near ROPAR. At present, Ranbaxy is the second

most Indian company engaged in the manufacturing of Pharmaceuticals, Bulk Drugs and

Fine Chemicals.

RANBAXYs vast range of highly pure laboratory reagent and chemicals enjoy a place of

pride in the market. IT trends, has rebuilt As a step towards leveraging information for

value creation using its information backbone around an ERP application, along the focus

on reengineering several business processes around the internet and has putting place

business solutions that challenge existing ways of doing Business. The undying spirit ofthe companys human assets and their intensive competitive and entrepreneurial energy


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has played a great part in transforming the company into a multicultural and multiracial

team. Today, Ranbaxy is the largest exporter accounting for 12% of the industry exports

pharmaceutical substance and dosages forms to over 50 countries with the internationals

sales comprising of 45% of the total turnover.

VISION: GARUDA

During the year 2002, the company has evolved a 10-year vision till 2012, for sustaining

significant growth consistent with its mission to be an international research based

Pharmaceutical Company, under the rubric Vision Garuda, with increasing emphasis on

Novel Drug Delivery Systems Research (DDR).

In licensing and out licensing, relationship with other important pharmaceutical entities,

expansion of manufacturing facilities both in India and strategic overseas locations,

revamping of organizational structures to cater to the wider and more dispersed span of

operations, and streamlining and standardizing the business processes through out the

global organization, are other areas that receive focus and attention of management on

priority.


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Mission

To become a Research based

International pharmaceutical company

Vision-2012

Achieve significant business in

Proprietary prescription products

By 2012

With a strong presence in developed markets

Aspirations-2012

Aspire to be a$5 billion company

Become a Top 5 global generics player

Significant income from Proprietary products

OPERATING JOINT VENTURES AND SUBSIDIARIES

BRAZIL : Ranbaxy S.P. Medicamentos Ltd.

CHINA : Ranbaxy (Guangzhou China) Ltd.

EGYPT : Ranbaxy Egypt Ltd.

GERMANY : Basics Gmb H.

HONG KONG : Ranbaxy (Hong Kong) Ltd.

INDIA : Rexcel pharmaceuticals Ltd.,

Solus pharmaceuticals Ltd.,


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Vidyut Travel Services ltd.

IRELAND : Ranbaxy Ireland Ltd.

MALAYSIA : Ranbaxy (Malaysia) Sdn. Bhd.

NETHERLANDS : Ranbaxy Pharmaceuticals B.V.

NIGERIA : Ranbaxy Nigeria Ltd.

PANAMA : Ranbaxy Panama SA.

POLAND : Ranbaxy Poland Sp. Zo.

SOUTH AFRICA : Ranbaxy (SA) (Pty.) Ltd.

THAILAND : Unichem pharmaceuticals LTD.,

Unichem Distributors Ltd. Part,

Ranbaxy Unichem CO.Ltd.

U.K : Ranbaxy (UK) Ltd

USA : Ranbaxy pharmaceuticals Inc.

Ohm Laboratories Inc.,

Ranbaxy Schein Pharma, LLC

VIETNAM : Ranbaxy Vietnam Company Ltd.


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ALLIED BUSINESSES

Ranbaxy Animal Health

`The Animal Health division saw an encouraging growth despite the prevailingpoor market conditions. The division grew at twice the growth rate recorded in the

industry. On the basis of having a vast dome satiated animal population, the livestock,

poultry business and pets business are among the fastest growing sectors in India. A vast

infrastructure of veterinary colleges, agricultural institutes, technologists and researchers

are helping farmers to source healthy, cost effective products. In conjunction with the

present scenario, the AHC division of Ranbaxy Laboratories Limited has introduced

several latest generation products.

Ranbaxy Fine Chemicals Limited (RFCL)

The division ranked 4th in the industry and captured 11% market share. RANKEM

is established as a powerful brand, RFCL's brand for its range of Reagents is now

synonymous with excellence in reagents and fine chemicals in the country. The focus of

business remains on developing extensive customer relations; enhancing service levels and

enriching the product mix with the help of a qualified and competent marketing and sales

team

Diagnostics

The diagnostics division has

aggressively focused on market

expansion activities based on strategy

of reliability, quality products and


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efficient service. Introduction of products in Point of Care markets has expanded market

presence and over the next 1 2 years this segment will see considerable expansion in line

with world trends.

The Dade Behring segment has increased its installation base by 60% in leading

hospitals and laboratories. Plans are afoot for the introduction of more parameters for the

Point of Care market and the launch of Special Chemistries, a range of drug assays, plus

an entry into automated microbiology in both the Base and Dade Behring business areas.

The company has also witnessed significant milestones in the area of Novel DrugDelivery Systems (NDDS). The company has entered into strategic business arrangements

with companies such as Bayer AG, Glaxo-Wellcome, Eli-Lilly etc. for production and co-

marketing operations. Many innovative developments have been taking place in recent

times. The companys research team is capable of developing one NDDS product every 12

to 18 months. Also, two new products: Roletra-D and Altiva-D, will soon be launched in

India.

In order to expand and promote global growth, the company opened several new

markets during the year, notably in Brazil, where 25 filings were undertaken in a span of

2-3 months.

The company has planned to build and protect intellectual property with the help of

IPC, which addresses all matters pertaining to patents. CQA supervises the

implementation of standard operating procedures (SOP) and ensures compliance to

corporate quality assurance policy in all technological operations of the organization. The

company is committed to invest 6% of the sales in R and D by 2003, of which 7% of the


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expenditure will be earmarked for research on New Drug Discovery and Novel Drug

Delivery Systems. There will be continuous emphasis on augmenting R and D

performance and productivity with advanced scientific and technological tools.

VALUES OF RANBAXY LABORATORIES LIMITED

1. Achieving customer satisfaction is fundamental to their business.

2. Practice dignity and equity in relationships and provide opportunities for people to

realize their full potential.

3. Ensure profitable growth and enhance wealth of shareholders.

4. Foster mutually beneficial relationships with all their business partners.

5. Manage their operations with concern for safety and environment.

6. Be a responsible corporate citizen.


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OBJECTIVES OF RANBAXY LABORATORIES LTD.

1. To be a leader in the Pharmaceutical industry.

2. To be a profitable company with a steady growth in earnings.

3. To set an example as a socially responsible company.

4. To diversify in health care related areas.

5. To strive for excellence and continuous improvement in all spheres.

6. To improve the quality of life of people by providing better services and quality

products.

Environment, Health and Safety [EHS]

Caring for the Environment is a core corporate value and as a part of this commitment.

The Company enunciated its EHS policy in 1993.

The Companys EHS policy provides for the creation of a safe and healthy workplace and

a clean environment for employees and the community. It aims at higher international

standards in plant design, equipment selection, maintenance and operations. The policy

seeks to manufacture products safely and in an environmentally responsible manner.

The implementation of the EHS Policy is ensured by institutionalizing a robust EHS

Management system, adequately supported by well defined organizational structure.

As a part of EHS processes at the corporate level, besides laying down guidelines

on systems, policy and training, the corporate EHS office monitors compliance, maintains

and disseminates information on laws and regulations. EHS performance review meetings

are held on regular basis to monitor the progress against agreed EHS improvement plans.

Close cooperation between all units and individuals is the key to maintaining high

standards of environment protection and safety in all the plants.

The key processes at location level comprise of regular safety surveillance,

inspections & audits, Permit to work system for operational / maintenance safety, Fire


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prevention & protection activities, operation of the ETP/Incinerator, disposal activities

related to hazardous wastes, regular monitoring of the environment internally and also

through approved laboratories. Monthly reports address EHS initiatives, compliance &

various records under the statutory requirement, training of employees including contract

employees on EHS awareness, interaction with the residential associations/nearby

community etc., celebration of National safety day, fire day, Environment day etc. for

EHS awareness among employees.

The manufacturing facilities for bulk drugs and dosage forms comply with the

stringent requirements of Good Manufacturing Practices (GMP) and Good Laboratory

Practices (GLP) and are approved by International health and regulatory Agencies like

FDA - USA, MCA UK, WHO etc. These practices and approvals ensure that an

effective framework is always in place, not only for manufacture of high quality products,

but also for effective use of resources and reduction of wastes as well as high safety &

hygiene standards.

Ranbaxy has made significant improvements in process safety of the existing

manufacturing facilities by providing extensive instrumented safety protection systems.

The intended safety features are incorporated in the basic design of the new projects.

Investments have been made on process improvements as well as effluent treatment plant

up-gradation using the latest membrane based technology, multi-effect thermal

evaporation system and state-of-the-art Incinerator. These investments have helped to

reduce discharges of contaminants into the environment. With the facilities installed at

Toansa for recycling of the treated effluent, the site has achieved the status of zero

discharge site.

The Company also engages with the concerned authorities and industry in devising

responsible laws, regulations and standards and thus making safety, occupational health &

environmental information and expertise available to its employees and the community at

large. Ranbaxy has made EHS concerns and practices a necessary factor in appraising its

employee performance.

The Company also accords a very high priority to hygiene monitoring at work

place and health assessment of all employees at site. The plant and processes are


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continuously upgraded to improve hygiene and health standards. Necessary training is

imparted to the employees to enhance their awareness towards health related matters.

Safety knowledge of the employees is constantly updated through various external

and in-house training programs, including special training programs by overseas experts &

consultants.

Moving up the value chain, the company identified Consumer Healthcare as its

new business area in the year 2001. Ranbaxy Global Consumer Healthcare (RGCH) was

launched in October 2002 with a portfolio of 4 switch brands: Revital, Pepfiz, Gesdyp &

Garlic Pearls. Since these brands were already popular amongst consumers and

represented the leading common ailment categories like VMS (Vitamins & Minerals

Supplement), this portfolio was carefully created for the introduction of RGCH to the

Indian market. Subsequently in 2004, RGCH launched its first herbal range of products

through New Age Herbals (NAH) with products offering remedy in categories of Cough

& Cold (Olesan Oil & Cough Syrups) and Appetite Stimulant (Eat Ease).

VARIOUS DIVISIONS OF RANBAXY LABORATORIES LTD.

1. Chemical Division

2. Diagnostic Division

3. Stan care Division

4. Curradia Division

5. International Division

6. Pharmaceutical Division

7. Technical Division

8. Corporate Division


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9. Animal Health Care Division

DIVISIONS IN VARIOUS GEOGRAPHICAL AREAS

1. India and Middle East

2. Europe, CIS and Africa

3. Asia Pacific and Latin America

4. North America

JOINT VENTURE OF THE COMPANY.

2000 Ranbaxy files IND Application for Asthma Molecule-

RBx4638, after successful completion of pre-clinical

studies.Ranbaxy acquires Bayers Generics business (trading

under the Name of Basics) in Germany.

Ranbaxy forays into Brazil, the largest pharmaceutical

market in South America and achieves global sales of U.S. $

2.5 million in this market.

2001 Ranbaxy took a significant step forward in Vietnam by

initiating the Setting up of a new manufacturing facility with

an investment of U.S. $ 10 million.


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Ranbaxy achieved a turnover of U.S. $ 502 million for the

year 2002 and moved closer to achieving a target of 1 billion

dollar by 2004.

2002 Receives approval from FDA to market Midazolam

Hydrochloride Syrup 2 Mg base/ ml. Ranbaxy receives and

approval from FDA to manufacture and market

Cefpodoxime Proxetil for Oral Suspension, Lisinopril +

Hydrochlorothiazide Tablets Us, Terazosin Hydrochloride

Capsules and Amoxcillin Oral suspension USP.Heralding

the companys entry into the Indian OTC market.

2003 Ranbaxy received the economic times award for corporate

excellence-for the company for year.ranbaxy signed an

agreement toacquire RPG(aventis) SA along with its fully

owned subsidiary,OPIH SARL,in france

2004 Ranbaxy launched its first range of herbal projects.

2005 Acquisition of additional stake in Ranbaxy FarmaceuticaLtda., Brazil Ranbaxy announced the acquisition of Be-

Tabs Pharmaceuticals (Pty) Limited

2008 Acquired by the Japanese giant, the $9.62 billion Daiichi

Sankyo, ranked No. 3 in Japan

BRIEF INTRO OF RANBAXY PLANTS IN INDIA

In the chemical division, various bulk drugs are manufactured. The chemical

division had three units in Punjab. One is located at Toansa, two are located at Mohali and

one unit is located at Dewas near Indore in Madhya Pradesh, where Ciprofloxacine is

manufactured. In the plant of the chemical division, various drugs like Antibiotics, Anti-

malarial, Antibacterial and Anti-ulcer are manufactured. One of the older plants of

Ranbaxy was closed after the accident in June 2003.the second one is still working

The 1991, the Toansa plant started functioning in 1992 and the Dewas plant startedfunctioning in 1999. Various plant heads independently manage all these plants.


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In each unit, separate facilities with respect to the manufacture of drugs, along with

their manufacturing areas have been provided. This is required to reduce the chances of

any cross contamination under the drug laws and to comply with good manufacturing

practices.

At Mohali plant, separate blocks have been provided for the preparation of each

drug .The Toansa, Mohali and Dewas plants are planned in such a way that their system,

facilities, manufacturing practices and standards meet the requirements of FDA. Mohali

Plant also mainly in the manufacturing of Active Pharmaceutical Ingredients (API). The

Plant is divided into two plant areas A8 and A9

HE VARIOUS DEPARTMENTS

Human Resource Department

The basic function of the human resource department in the modern corporate

world is knowledge management. The HR department strives to maintain cohesiveness

among employees. It also ensures interdepartmental cooperation in achieving targets. The

appraisal system is also taken care by this department. The HR department delves deep

into the employees psyche to analyze the positives and negatives of each employee, so

that a proper system of delegation and / or empowerment can be evolved.

Finance Department

The finance department takes care of the regular financial needs of the company it

ensures proper allocation of funds and takes care of the working capital requirements. It

verifies capital raised by different departments and sends them for approval to the higher

authorities.

Stores Department

The function of this department is to provide adequate and proper storage and

preservation of various items to meet the demand of various other departments by proper

issues and maintaining accounts of consumption. It also keeps a track of stock

accumulation and abnormal consumption.

Erection and Fabrication Department


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As the name suggests, this department identifies new projects and helps in erecting

them. This department also undertakes major modifications of equipment.

ERP Department

ERP department helps to integrate the entire enterprise starting from the supplier to

the customer, covering financial and human resources. This will enable the enterprise to

increase productivity by reducing costs. It also ensures a single solution to the information

needs of the whole organization.

Production Department

As a part of their ongoing commitment to produce hi-tech quality drugs andpharmaceuticals that take care of the specific needs of markets around the world, Ranbaxy

Laboratories Limited has increased the investment in the production department. It is the

most important department of the company and has the following objectives:

1. Improving volume of production.

2. Reducing rejection rate.

3. Maintaining rework rate.

Engineering Department

This department undertakes building, construction and maintenance. Maintaining

service facilities such as water, gas, heating, ventilation, air conditioning, painting and

plumbing are some of the other areas dealt by this department. This department also helps

in maintaining electrical equipments such as generators, transformers, telephone system

and electrical installation.

Purchase Department

The purchase department provides material to the factory without which the wheels of

machines cannot move. The various functions performed by this department include:

Securing good vendor performance, including prompt deliveries of supplies of acceptable

qualities.


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1. To develop satisfactory sources of supply and maintaining good relationships with

the suppliers.

2. To pay reasonably low prices.

Quality Control/Quality Assurance Department

The purpose of QC & QA departments is to ensure that the desired quality standard

is achieved. It also ensures that the processing or fabrication of material conforms to the

specific characteristics selected, to assure that the resulting product will in fact perform its

intended function.

PRODUCT REVIEW

Ranbaxys therapeutic width covers five of the top six categories including Anti-

infective, Gastrointestinal, Nutritionals, Cardiovascular, Central Nervous System,

Respiratory, Dermatological and others. While anti-infective contribute 56% of the total

sales, Ranbaxys other brands like Simvotin and Storvas in the cardiovascular segment,

Serlift in CNS and Revital and Riconia in Nutritionals, are on their way to success in

multiple markets.

During Jan - Dec 2000, amongst the top products of Ranbaxy, Sporidex

(Cephalexin) was the Number 1 brand, closely followed by Cifran (Ciprofloxacin).

Anti - Infectives

Anti- infective has been the main driver of Ranbaxys sales. The important brands

in this category are Cifran (Ciprofloxacin), Sporidex (Ciphalexin), Enhancin

(Amoxyclav), Crixan (Clarithromycin), Vercef (Cefaclor), Oframax (Ceftriaxone),Cepodem (Cefpodoxime Proxetil), Zanocin (Ofloxacin), Ceroxim (Cefuroxime Axetil),

and Loxof (Levofloxacin).

Cifran (Ciprofloxacin) is the key brand in the anti- infective portfolio, with

estimated sales of US $ 32 Mn, currently being marketed in 15 countries. Development of

Ciprofloxacin once a day has been an important landmark achieved by Ranbaxy. The

product has been licensed to Bayer. Cifran continues to be a dominant player in the

quinolones market in India, China and Russia.


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Sporidex is another leading brand in Ranbaxys product portfolio with worldwide

annual sales of US $ 35 Mn. It is available in eight different dosage forms including

capsules, dry powder for suspension, redimix, dispersible tablets, paediatric drops, soft

gelatin capsules, sachet and advanced formulation for twice-daily administration. It is

currently marketed in 15 countries. In India, Sporidex is the leading brand with a market

share of 36% of the Cephalexin segment.

Keflor is available in seven different dosage forms and is the third-largest selling

brand for Ranbaxy worldwide. The dosage forms list includes capsules, dry syrup,

modified release tablets, dispersible tablets, drops and redimix.

Enhancin is expected to be the leading product in Ranbaxys product portfolio with

estimated sales of US $ 45 Mn by the year 2005. The product will be rolled out to about

20 important markets during this period.

Zanocin, with approximate sales of US $ 10 Mn, is the seventh-largest contributor

to Ranbaxys total sales.

Cepodem is currently available in three different countries outside India, and will

be rolled out to 13 different countries in the near future.

Cardiovasculars

Cardiovascular is projected to be the second-best category for Ranbaxy. Statins

have been the key drivers for this segment. The sale of Simvastatin has grown

substantially in the past few years, a trend that is likely to continue in the future. In India,

Simvotin (Simvastatin) is the market leader in the cholesterol reducer segment. Another

leading brand in this category is Storvas (Atorvastatin). Storvas has been one of the

fastest-ever to enter the top-300 brands list of the Indian pharma industry. Other global

cardiovascular brands are Covance (Losartan) and Caslot (Carvedilol).

Central Nervous System


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The Central Nervous Segment is one of the important focus areas identified by

Ranbaxy, with Serlift being the key brand. In India, Serlift is number 1 amongst Sertraline

brands. New product introductions will be drivers of growth in this category.

Gastrointestinal

Currently, gastrointestinal drugs are the second-largest category for Ranbaxy. The

key brands in this category include Histac and Romesac. The current annual sales of

Ranitidine are estimated to be around US $ 16 Mn and the product is marketed in more

than 20 countries.

Rheumatologicals

The first generation Cox-2 inhibitors principally drive worldwide growth in

rheumatology. This category is estimated to grow exponentially for Ranbaxy, with brands

like Celecoxib. This year, Rofibax (Rofecoxib) introduced in India, has established itself

as a leader in the Cox-2 inhibitor category and has overtaken all Celecoxib brands. It has

been identified as a key Global brand for the future.

Nutritonals

Nutritionals have been a major contributor to Ranbaxys sales. Two of the

important products in this category are Revital and Riconia. With annual sales estimated at

about US $ 10 Mn, Revital contributes a significant share of total sales. It is a leading

brand in India and has done exceedingly well in some parts of the world as an OTC

product.

Dermatologicals

The dermatology category is mainly driven by India region and is likely to show a

good growth pattern in the future. Some of the key brands doing well in this segment are

Mobizox, Silverex, Moisturex, etc.


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INTRODUCTION TO CAPITAL STRUCTURE THEORY AND

ANALYSIS

This is a Report on the Capital Structure and Capital Expenditure of Ranbaxy

Laboratories Ltd.. The purpose and scope of the project can be listed as:

Understanding the organizational structure and functioning of Ranbaxy

Laboratories Ltd.

Analysing and comparing the financial health of the firms in the Indian

Pharma Industry.

Identifying and analysing the capital structure of Ranbaxy.

Conducting a Review of the Capital Expenditure done at Ranbaxy

Laboratories Ltd.

Identifying loopholes in the functioning and in the area of study and

recommending the suggestions for the same.

Following are the limitations of the study:

Balance sheets of only 3 years have been studied but the company is in

operation for so many years.

Only specific tools (i.e. ratio analysis) have been used for data analysis, while

so many other tools are also there.

Organizational rules & regulations.

Availability of data. Financial figures for 2008 of Ranbaxy were not available.

Limitations of the financial tools used.

Literature of review on Capital Structure


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capital structure is a mix of debt and equity capital maintained by a firm. Capital

structure is also referred as financial structure of a firm. the capital structure of a firm is

very important since it related to the ability of the firm to meet the needs of its

stakeholders. Modigliani and miller (1958) were the first ones to landmark the topic of

capital structure and they argued that capital structure was irrelevant in determining the

firms value and its future performance. on the other hand, lubatkin and chatterjee (1994)

as well as many other studies have proved that there exists a relationship between capital

structure and firm value. modigliani and miller (1963) showed that their model is no more

effective if tax was taken into consideration since tax subsidies on debt interest payments

will cause a rise in firm value when equity is traded for debt.

in more recent literatures, authors have showed that they are less interested on how capital

structure affects the firm value. Instead of the firm. modigliani and miller (1963) argued

that the capital structure of a firm should compose entirely of debt due to tax deductions

on interest payments. However, brigham and gapenski (1996) said that, in theory, the

modigliani-miller (mm) model is valid. But, in practice, bankruptcy costs exist and these

costs are directly proportional to the debt level of the firm. hence, an increase in debt level

causes an increase in bankruptcy costs. therefore, they argue that that an optimal capital

structure can only be attained if the tax sheltering benefits provided an increase in debtlevel is equal to the bankruptcy costs. in this case, managers of the firms should be able to

identify when this optimal capital structure is attained and try to maintain it at the same

level. this is the only way that the financing costs and the weighted average cost of capital

(wacc) are minimized thereby increasing firm value and corporate performance.

BOODHOO Roshan

ASc Finance, BBA (Hons) Finance, BSc (Hons) Banking & International Finance

(Email: [email protected] ; Tel: +230-7891888)

MethodologyMethodology

The methodology adopted for the study was as follows:


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Familiarization, examination and evaluation of the procedures relating to capital

structure and capital expenditure.

Collection of relevant data form company records and cross checking of this data.

Calculations of financial ratios, parameter and norms, as also their financial

implications.

Broadly the data were collected for the report on the project work has been

through the primary and secondary sources.

The primary data is collected by various approaches so as to give a precise,

accurate, realistic and relevant data. The main goal in the mind while gathering

primary data was investigation and observation. The ends were thus achieved by a

direct approach and personal observation from the officials of the company. The

other staff members and the employees were interviewed for the sake of

maintaining reasonable standard of accuracy.The secondary data as it has always

been important for the completion of any report provides a reliable, suitable

equate and specific knowledge. The annual reports, the fixed asset register and the

Capex register provided the knowledge and information regarding the relevant

subjects.

The valuable cooperation and continued support extended by all associated

personnels, head of the department, division and staff members contributed a lot to

fulfil the requirement in the collection of data in order to present a complete report on

the project work.

Capital Structure: Theory and Analysis

Capital Structure

Financing decisions involve raising funds for the firm. It is concerned with formulation

and designing of capital structure or leverage. The most crucial decision of any company

is involved in the formulation of its appropriate capital structure. The best design or

structure of the capital of a company helps the management to achieve its ultimate


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objectives of minimising overall cost of capital, maximising profitability and also

maximising the value of the firm.

The capital structure decision of a firm is concerned with the determination of debt equity

composition. Capital structure ordinarily implies the proportion of debt and equity in the

total capital of a company. The term capitalmay be defined as the long term funds of the

firm. Capital is the aggregation of the items appearing on the left hand side of the balance

sheet minus current liabilities.

In other words capital may be expressed as follows:

Capital = Total Assets Current Liabilities.

Further, capital of a company may broadly be categorised into equity and debt. The total

capital structure of a firm is represented in the following figure:


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Established companies generally have track record of their profit earning capacity, which

helps them to create their creditworthiness. The lenders feel safe to invest their funds in

such companies. Thus, there is ample scope for this type of companies to collect debt. But

a company cannot freely i.e. without having any limit. The company must have to chalk

out a plan to collect a debt in such a way that the acceptance of debt becomes beneficial

for the company in terms of increase in EPS, profitability and value of the firm.

If the cost of capital is greater than the return, it will have an adverse effect on companys

profitability, value of the firm and its EPS. Similarly, if company is unable to repay the

debt within the scheduled period it will affect the goodwill of the company in the credit

market and consequently may create problems in future for collecting further debt. Other

factors remaining constant, the company should select its appropriate capital structure with

due consideration.

Capital structure involves a choice between risk and expected return. The optimal capital

structure strikes the balance between these risks and returns and thus examines the price of

the stock.

Significant variations with regard to capital structure can easily be noticed among

industries and firms within the same industry. So it is difficult to generate the model

capital structure for all business undertakings. The following is an attempt to consolidate

the literature on various methods to suggested by researchers in arriving at optimal capital

structure.

Notations used:

V = value of firm

FCF = free cash flow

WACC = weighted average cost of capital

rs and rd are costs of stock and debt

re and wd are percentages of the firm that are financed with stock and debt.


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Operating and Financial Leverages

The term leverage refers to the ability of a firm in employing long term funds having a

fixed cost, to enhance returns to the owners. In other words leverage is the employment of

fixed assets or funds for which a firm has to meet fixed costs or fixed rate of interest

obligation irrespective of the level of activities attained or the level of operating profit

earned.

Higher the leverage, higher the profits and vice versa. But a higher leverage obviously

implies higher outside borrowings and hence riskier if the business activity of the firm

suddenly takes a dip. But a low leverage does not necessarily indicate prudent financial

management, as the firm might be incurring an opportunity cost for not having borrowed

funds at a fixed cost to earn higher profits.

Operating Leverage

Operating leverage is concerned with the operation of any firm. The cost structure of any

firm gives rise to operating leverage because of the existence of fixed nature of costs. This

leverage relates to the sales and profit variations.

Operating

Leverage =

Contributio

n

EBIT

Contribution = Sales Variable Costs

EBIT = Earnings Before Interest and Taxes.


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Disadvantages of Operating Leverages

The reliability of operating ratios rests to a large extent on the correctness of the

fixed costs identified with a product. Faulty apportionment would distort the

usefulness of the ratio.

The published accounts does not give details of the fixed cost incurred and the

contribution from each product and for an outsider it is difficult to calculate the

firms operating leverage.

Firms cost structure and nature of the firms business affects operating leverage. A

degree change in sales volume results in more than proportionate change (+/-) in

operating (or loss) can be observed by use of operating leverage.

Financial Leverage

This ratio indicates the effects on earnings by rise of fixed cost funds. It refers to use the

use of debt in the capital structure. Financial leverage arises when a firm deploys debt

funds with fixed charge. The ratio is calculated with the following:

Earnings before interest and tax / Earnings after interest The higher the ratio,

the lower the cushion for paying interest on borrowings. A low ratio indicates a

low interest outflow and consequently lower borrowings. A high ratio is risky and

constitutes a strain on profits. This ratio is considered along with the operating

ratio, gives a fairly and accurate idea about the firms earnings, its fixed costs and

the interest expenses on long term borrowings.

Earnings per Share Higher financial leverage leads to higherEBITresulting in

higher EPS, if other things remain constant. Financial leverage affects the

variability and expected level ofEPS. The more debt the firm employs the higher

its financial leverage. Financial leverage generally raises expectedEPS, but it also

increases the riskiness of securities as the debt / asset ratio rises.


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Financial Leverage

=

EBIT

EBT

EBIT Earnings Before Interest and Tax

EBT Earnings Before Taxes.

Consider Two Hypothetical Firms

Firm U Firm L

No debt 10,000 of 12% debt

20,000 in assets 20,000 in assets

40% tax rate 40% tax rate

Both firms have same operating leverage, business risk, and EBIT of 3,000. They differ

only with respect to use of debt.

Impact of Leverage on Returns

Firm U Firm L (Fig. in Rs000)

EBIT 3,000 3,000

Interest 0 1,200

EBT 3,000 1,800

Taxes (40%) 1, 200 720

NI 1,800 1,080


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ROE 9.0% 10.8%

More EBIT goes to investors in Firm L.

Total dollars paid to investors:

U: NI = Rs.1,800.

L: NI + Int = Rs.1,080 + Rs.1,200 = Rs.2,280.

Taxes paid:

U: Rs.1,200; L: Rs.720.

Now consider the fact that EBIT is not known with certainty. Determining the impact

of uncertainty on stockholder profitability and risk for Firm U and Firm L

Firm U: Unleveraged

Economy (Fig. in Rs000)

Bad Avg. Good

Prob. 0.25 0.50 0.25

EBIT 2,000 3,000 4,000

Interest 0 0 0

EBT 2,000 3,000 4,000


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Taxes (40%) 800 1,200 1,600

NI 1,200 1,800 2,400

Firm L: Leveraged

Economy (Fig. in Rs000)

Bad Avg. Good

Prob.* 0.25 0.50 0.25

EBIT* 2,000 3,000 4,000

Interest 1,200 1,200 1,200

EBT 800 1,800 2,800

Taxes (40%) 320 720 1,120

NI 480 1,080 1,680

*Same as for Firm U.

Firm U Bad Avg. Good

BEP 10.0% 15.0% 20.0%

ROIC 6.0% 9.0% 12.0%

ROE 6.0% 9.0% 12.0%

TIE n.a. n.a. n.a.


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Firm L Bad Avg. Good

BEP 10.0% 15.0% 20.0%

ROIC 6.0% 9.0% 12.0%

ROE 4.8% 10.8% 16.8%

TIE 1.7x 2.5x 3.3x

U L

Profitability Measures:

E(BEP) 15.0% 15.0%

E(ROIC) 9.0% 9.0%

E(ROE) 9.0% 10.8%

Risk Measures:

sROIC 2.12% 2.12%

sROE 2.12% 4.24%

Conclusions

Basic earning power (EBIT/TA) and ROIC (NOPAT/Capital = EBIT(1-T)/TA)

are unaffected by financial leverage.

L has higher expected ROE: tax savings and smaller equity base.


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L has much wider ROE swings because of fixed interest charges. Higher

expected return is accompanied by higher risk.

In a stand-alone risk sense, Firm Ls stockholders see much more risk than Firm Us.

U and L: sROIC = 2.12%.

U: sROE = 2.12%.

L: sROE = 4.24%.

Ls financial risk is sROE - sROIC = 4.24% - 2.12% = 2.12%. (Us is zero.)

For leverage to be positive (increase expected ROE), BEP must be > rd.

If rd > BEP, the cost of leveraging will be higher than the inherent profitability

of the assets, so the use of financial leverage will depress net income and ROE.

In the example, E(BEP) = 15% while interest rate = 12%, so leveraging works.

Choosing the Optimal Capital Structure for Ranbaxy Laboratories Ltd.

Based on the ratio analysis done above it can be concluded that Ranbaxy is an unleveared

firm with very less debt component in its capital structure. The company is in a position to

increase its debt component by resorting to external debt financing. However it should be

kept in mind that, there could be two opposite effects if debt is increased in the capita

structure. The first effect may be an overall reduction in the cost of capital as the

proportion of debt increases in the capital structure due to low cost of debt. On the other

hand, because of fixed contractual obligation the financial risk of the company increases.

Thus, it is said that the optimum capital structure implies a ratio of debt and equity at

which weighted average cost of capital would be least and the market value of the firm

would be highest.

Keeping the above thought in mind I have tried to compute what would be the optimal

capital structure for Ranbaxy


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Laboratories Ltd., based on the following information as per the Annual Report 2005:

EBIT being 37,273,800;

Assuming that the firms expects zero growth

225,557,810 shares outstanding; rs = 12%;

T = 35%; b = 1.0; rRF = 6%;

RPM = 6%.

Estimates of Cost of Debt

Percent financed

with debt, wd rd

0% -

20% 8.0%

30% 8.5%

40% 10.0%

50% 12.0%

If company recapitalizes, debt would be issued to repurchase stock.

The Cost of Equity at Different Levels of Debt: Hamadas Equation

MM theory implies that beta changes with leverage.


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bU is the beta of a firm when it has no debt (the unlevered beta)

bL = bU [1 + (1 - T)(D/S)]

The Cost of Equity for wd = 20%

Use Hamadas equation to find beta:

bL

= bU

[1 + (1 - T)(D/S)]

= 1.0 [1 + (1-0.35) (20% / 80%) ]

= 1.16

Use CAPM to find the cost of equity:

rs = rRF + bL (RPM)

= 6% + 1.16 (6%) = 12.98%

Cost of Equity vs. Leverage

wd D/S bL rs

0% 0.00 1.00 12.00%

20% 0.25 1.16 12.98%

30% 0.43 1.28 13.67%

40% 0.67 1.43 14.60%

50% 1.00 1.65 15.90%


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The WACC for wd = 20%

WACC = wd (1-T) rd + we rs

WACC = 0.2 (1 0.35) (8%) + 0.8 (12.98%)

WACC = 11.42%

Repeat this for all capital structures under consideration.

WACC vs. Leverage

wd rd rs WACC

0% 0.0% 12.00% 12.00%

20% 8.0% 12.98% 11.42%

30% 8.5% 13.67% 11.23%

40% 10.0% 14.60% 11.36%

50% 12.0% 15.90% 11.85%

Corporate Value for wd = 20%

V = FCF / (WACC-g)

g=0, so investment in capital is zero; so FCF = NOPAT = EBIT (1-T).

NOPAT = (Rs.37,273,800)(1-0.35) = Rs.24,227,970


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V = Rs.24,227,970/ 0.1142 = Rs.212,153,852.89

Corporate Value vs. Leverage

wd WACC Corp. Value

0% 12.00% Rs.201,899,750.00

20% 11.42% Rs.212,153,852.89

30% 11.23% Rs.215,791,315.97

40% 11.36% Rs.213,274,383.80

50% 11.85% Rs.204,455,443.04

Debt and Equity for wd = 20%

The value of debt is:

= wd V = 0.2 (Rs.212,153,852.89) = Rs.42,430,770.58.

S = V D

S = Rs.212,153,852.89 Rs.42,430,770.58 = Rs.169,723,082.31

Debt and Stock Value vs. Leverage

wd Debt, D Stock Value, S

0% 0 Rs.201,899,750.00

20% Rs.42, 430,770.58 Rs.169,723,082.31

30% Rs.64, 737,394.79 Rs.151,053,921.18

40% Rs.85, 309,753.52 Rs.127,964,630.28


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50% Rs.102, 227,721.52 Rs.102,227,721.52

Wealth of Shareholders

Value of the equity declines as more debt is issued, because debt is used to repurchase

stock.

But total wealth of shareholders is value of stock after the recap plus the cash received in

repurchase, and this total goes up (It is equal to Corporate Value on earlier slide).

Stock Price for wd = 20%

The firm issues debt, which changes its WACC, which changes value.

The firm then uses debt proceeds to repurchase stock.

Stock price changes after debt is issued, but does not change during actual repurchase (or

arbitrage is possible).

The stock price after debt is issued but before stock is repurchased reflects

shareholder wealth:

S, value of stock

Cash paid in repurchase.

D0 and n0 are debt and outstanding shares before recap.

D - D0 is equal to cash that will be used to repurchase stock.


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S + (D - D0) is wealth of shareholders after the debt is issued but immediately before the

repurchase.

P = S + (D D0)

n0

P = Rs.169,723,082.31+ (Rs. 42,430,770.58 0)

225,557,810

P = Rs.94.06 per share.

# Repurchased = (D - D0) / P

# Rep. = (Rs.42,430,770.58 0) / Rs.94.06

= 45,116.

# Remaining = n = S / P

n = Rs.169,723,082.31 / Rs.94.06

= 1,804,462.

Price per Share vs. Leverage

# shares # shares

wd P Repurch. Remaining

0% Rs.89.51 0 2,255,578

20% Rs.94.06 451,116 1,804,462

30% Rs.95.67 676,673 1,578,905


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40% Rs.94.55 902,231 1,353,347

50% Rs.90.64 1,127,789 1,127,789

Optimal Capital Structure

wd = 30% gives:

Highest corporate value

Lowest WACC

Highest stock price per share

But wd = 40% is close. Optimal range is pretty flat.

Modigliani and Miller Theory (Modern View)

The traditional view of capital structure explained in weighted average cost of capital is

rejected by the proponentsModigliani and Miller (MM) (1958). According to them, under

competitive conditions and perfect markets, the choice between equity financing and

borrowing does not affects a firms market value because the individual investor can alter

investment to any mix of debt and equity the investor desires.

Assumptions of MM Theory

TheMM Theory is based on the following assumptions:

Perfect capital markets exist where individuals and companies can borrow

unlimited amounts at the same rate of interest.

There are no taxes or transaction costs.

The firms investment schedule and cash flows are assumed constant and

perpetual.


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Firms exist with the same business or systematic risk at different levels of gearing.

The stock markets are perfectly competitive.

Investors are rational and except other investors to behave rationally.

MM Theory: No Taxation

The debt is less expensive than equity. An increase in debt will increase the

required rate of return on equity. With the increase in the levels of debt, there will be

higher level of interest payments affecting the cash flow of the company. Then equityshareholders will demand for more returns. The increase in cost of equity is just enough to

offset the benefit of low cost debt, and consequently average cost of capital is constant for

all levels of leverage as shown in Figure 1.

Figure 1: MM view of Capital Structure

InMM theory the following notations will be used:

rCost of Capital

Cost of

Equity

Average cost of

Capital

Cost of

Debt


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Vu = Market value of ungeared company i.e. company with 100% equity

financing.

Vg = Market value of a geared company i.e. capital structure of the

company includes both debt and equity capital.

D = Market value of debt in a geared company.

Ve = Market value of equity in a geared company.

Vg = Ve + D

Ku = Cost of equity in an ungeared company.

Kg = Cost of equity in a geared company.

Kd = Cost of Debt.

M M Theory: Proposition I

The market value of any firm is independent of its capital structure, changing the

gearing ratio cannot have any effect on the companys annual cash flow. The assets in

which the company has invested and not how those assets are financed determine the

market value. Thus, the market value of a firm is unaffected by its financing decisions,

its capital structure, or its debt-equity ratio.

In simple words, M & M theory views the value of the company as a whole pie. The

size of the pie does not depend on how it is sliced i.e. the firms capital structure but

rather the size of the pie pan i.e. the firms present value based on its future cash flows

and its asset base.

The value of the geared company is as follows:

Vg = Vu

Vg = Profit before interest

WACC


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Vg = Vu = Earnings in ungeared company

Ku

WACC is independent of the debt / equity ratio and equal to the cost of capital which thefirm would have with no gearing in its capital structure.

Proof by example -

Consider holding 1% of stock in an all-equity firm with value VU.

Then your wealth is 0.01VU.

Also, you receive a cash flow of 0.01CF t every period.

Alternatively, consider holding 1% equity and 1% debt in levered

version of the same firm with value Vg=E+D.

Your wealth then is [0.01E+0.01D] = 0.01Vg.

Cash Flows each period? [0.01(Int)+0.01(CF t-Int)]=0.01CFt.

As the inherent risk of the firm is the same, then the discounted

value of the cash flows must be the same, i.e., Vg= VU.

Prop. IWACC

M&M

E

Traditional


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MM Theory: Proposition I

M M Theory: Proposition II

The rate of return required by shareholders increases linearly as the debt / equity ratio isincreased i.e. the cost of equity rises exactly in line with any increase in gearing to

precisely offset any benefits conferred by the use of apparently cheap debt.

MMwent on arguing that the expected return on the equity of a geared company is equal

to the return on a pure equity stream plus a risk premium dependent on the level of capital

structure.

The premium for financial risk can be calculated as debt / equity ratio multiplied by thedifference between the cost of equity for ungeared company and risk free cost of debt.

The cost of equity depends on the following three variables:

1. The required rate of return on the firm (K u).

2. The required rate of return on the firms debt (K d).

3. The firms debt/equity ratio (D/E)

MM proposition IIcan be summed up in following points:

Equity holders require a premium over what everyone is paid if the firm has debt.

The premiumDOESdepend upon the firms financing mix.

The wealth of equity holders, however, is unaffected.

Any increase in leverage raises both the risk of equity and its required return.

( )D

Vgg u u d= +


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Stockholders are indifferent to capital structure and to change in leverage.

MM Theory: Proposition II

M M Theory: Proposition III

MM theorys third proposition asserts that the cut-off rate for new investment will in all

cases be average cost of capital and will be un affected by the type of security used to

finance the investments.

M M Theory: Arbitrage

The cost of equity will rise by an amount just sufficient to offset any possible saving or

loss. The lenders determine the supply of debt. The optimal level is simply the maximum

amount of debt which lenders are prepared to subscribe in any given circumstances e.g.

level of inflation, rate of economic growth, level of profits etc. the investors will exercise

their own leverage by mixing their own portfolio with debt and equity. The investors call

this the arbitrage process. Under these conditions of investment the average cost of capital

is constant.

If two different firms with same level of business risk but different levels of gearing soldfor different values, then shareholders would move from over valued firm to the under

Prop. IIR

E

M&M

Slope =RA

RD

B

E

TraditionalRA


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value firm and adjust their level of borrowing through the market to maintain financial risk

at the same level. The shareholders would increase their income through this method while

maintaining their net investment and risk at the same level. This process of arbitrage

would drive the price of the two firms to a common equilibrium total value.

The word arbitrage is a technical term referring to a situation where two identical

commodities are selling in the same market for different prices, then the market will reach

equilibrium by the dealers start at the lower price and sell at the higher price, thereby

making profit. The increase in demand will force up the price of the lower priced goods

and increase in supply will force down the price of the high priced commodities.

The arbitrage inMM theory shows that the investors will move quickly to take advantage

and will make profit in an equilibrium capital market, then this would represent an

arbitrage opportunity.

MM Theory: Corporate Taxation

In above discussion,MM theory has ignored the tax relief on debt interest. MMhas further

modified their theory by considering tax relief available to a geared company when the

debt component exists in the capital structure. The tax burden on the company will lessen

to the extent of relief available on interest payable on the debt, which makes the cost of

debt cheaper, which reduces the weighted average capital of the lower where capital

structure of a company has debt component.

Consider a firm with no debt (i.e. all equity or unlevered) with a value of V u.

Suppose firm changes capital structure by issuing debt and retiring some equity. The f irm

will realize gain since interest payments on debt are tax-deductible, so tax liability willdecline!

For perpetual debt:

Yearly Tax Savings (Tax Shield)

= Interest TC = r D TC

= RD B TC


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VL

VU

Tax shield will be realized each year forever. Since it goes to bondholders, it should be

discounted at RD, thus

PV of tax shield = (RD B TC)/ RD

= B TC

Value of firm with debt VL (i.e. levered firm) will be : VL = Vu + B TC

Value increases by PV of tax shield.

Tax advantage of debt increases as TC increases.

In M&M world (TC = 0), VL = V

B

MM Theory: Corporate Taxation

Slope = TC

PV of Tax Shield

M&M Value


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Under the assumption of tax relief being available on debt interest, the total market value

of the company is increasing function of the level of gearing.

MM theory cost of equity formula for a geared company:

Kg = Ku + (1 T) (Ku Kd)

MM theory assumes that the value of the geared company will always be greater than an

ungeared company with similar business risk but only by the amount of debt associated

tax saving of the geared company. Value of geared company:

Vg= Vu + DT

When corporation taxation is introduced, the tax deductibility of debt interest creates value

for shareholders via the tax shield, but this is a wealth transfer from taxpayers. The value

of a geared company equals the value of an equivalent ungeared companys shareholders

is less than that in the all equity company, reflecting the tax benefits. A further effect of

corporate taxation is to lowerWACC, which falls continuously as gearing increases.

MM Theory: Personal Taxation

MM theory considered only corporate taxes. It was left to a subsequent analysis by Miller

(1977) to include the effects of personal as well as corporate taxes. He argued that the

existence of tax relief on debt interest but not on equity dividends would make debt capital

more attractive than equity capital to companies. The market for debt capital under the

laws of supply and demand, companies would have to offer a higher return on debt in

order to attract greater supply of debt. When the company offers after personal tax return

on debt at least as equal to the after personal tax return on equity, the equity supply will

switch over to supply debt to the company. It is assumed that, from the angle of the

company, it will be indifferent between raising debt or equity as the effective cost of each

will be the same and there is no advantage to gearing.


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Financial Distress and Capital Structure

The assumption is that when firm has very high level of borrowing they are more likely to

run into the cost of final distress and cost of bankruptcy. When the leverage of the firm is

extremely high then it is very likely that at some stage it will not be able to make annual

interest payments and loan repayments. Dividends for shareholders can be bypassed but

failure to pay interest on loans often gives the lender the right to claim on the firms

operating assets thereby preventing the firms continuity of activity.

The following illustrative list of activities which may cause increase in cost of the firm.

Successive borrowings beyond the companys target debt equity ratio.

Borrowing higher levels of interest

Skip off or cut in dividend which may cause the fall of market rate of shares.

Loss of trade credit from suppliers

Distress sale of highly profitable instruments.

Abandonment of promising new projects.

Reduced credit period resulting in loss of business.

Corporate image may be tarnished.

Demand for withdrawal of loans made to the firm previously.

Reduction in stock levels result in reduction in sales etc.

Bankruptcy Costs


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The cost of bankruptcy may be of two types:

Direct costs

Those directly associated with bankruptcy, both legal and administrative.

Indirect costs

Costs associated with a firm experiencing financial distress (creditors,

bankers, customers, employers, etc.)

Bankruptcy costs = direct costs + indirect costs

An increase in debt is associated with increased tax savings but also an increased

probability of running into cost of financial distress and bankruptcy. The value of the

leveraged firm is its capitalised after tax operational cash flow plus the present value of

the tax savings incorporating the anticipated cost of financial distress and bankruptcy.

V = X + DT BC

R

Where,

V = Value of leverage firm

X = Anticipated net operational cash flows

R = Capitalisation Rate

D = Market Value of Debt

T = Corporate tax rate

BC = Anticipated costs of bankrupting


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Figure: Optimum Capital Structure and Costs of Financial Distress

The existence of tax benefit for modest amounts of debt, and the need to avoid the costs of

financial distress, suggest that there is an optimal capital structure as illustrated in figure

PV of Tax Shield

V

VU

PV ofBankruptcy Cost

B

Cost of Equity

Optimum Capital

Structure


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which shows that there is an optimal capital structure at the point where the market value

of the firm is maximized, that is where (DT BC) is maximized.

Debt Financing and Agency Costs

Agency theory models a situation in which a principal (a superior) delegates decision

making authority to an agent (the subordinate) who receives reward in return for

performing some activity on behalf of the principal. The outcome of the agents effects the

principals welfare in some way, for example sales revenue, output or contribution margin.

The principal attempts to combine a reward system with an information system, in order to

motivate the agent to choose the action, which maximizes the principals welfare.

In respect of debt finance, the suppliers of debt are much concerned, about their

investment in the company, about their investment in the company, about the risk involved

in financing debt to the company. In order to minimize the risks in debt finance, the

suppliers of loan will impose restrictive conditions in loan agreements that constraint

managements freedom of action and it is known as agency costs. The more money the

suppliers of debt lend to the company then the more constraints they are likely to impose

on the managements in order to secure their investments. Therefore, agency costs are

more in highly geared firms.

Difficult to identify and estimate, but exist

V = VU + BTC PVBC PV of agency costs

PVBC + PVAC eventually dominate over PV of tax shield.

PV of agency costs , as B generally.

PV of Tax Shield

V

VU

PVBC

+ PVAC

B


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Debt Financing and Agency Cost

Signaling Theory

In a pioneering study published in 1961, Gordon Donaldson examined how companies

actually establish their capital structure. The findings of his study are summarised below:

1. Firms prefer to rely on internal accruals, i.e. on retained earnings and depreciated

cash flow.

2. Expected future investments oppurtunities and expected future cash flow influence

target dividend payout ratio. Firms set the target pay out ratio at such a level that

capital expenditures, under normal circumstances, are covered by internal accruals.

3. Dividends tend to be sticky in the short run. Dividends are raised only when the

firm is confident that the higher dividend can be maintained; dividends are not

lowered unless things are very bad.

4. If a firms internal accruals exceed its capital expenditure requirements, it will

invest in marketable securities, retire debt, raise dividends, resort to acquisitions, or

buyback its shares.

5. If a firms internal accruals are less than its non-postponable capital expenditure, it

will first draw down its marketable securities portfolio and then seek external

finance.

Noting the inconsistencies in the trade off theory, Myers proposed a new theory, called

thesignalling, or asymmetric information, theory of capital structure. The main points of

the theory are:


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Managers often have better information.

Sell stock if stock is overvalued.

Sell bonds if stock is undervalued.

Investors understand this, so view new stock sales as a negative signal.

Corporate Finance Practices

The capital structure decision is a difficult decision that involves a complex trade off

among several considerations like income, risk, flexibility, etc. given the over riding

objective of maximising the market value of a firm, the following guidelines should be

kept in mind while hammering out the capital structure of the firm.

Avail of the Tax Advantage of Debt.

Interest on debt finance is a tax deductible expense. Hence finance scholars and

practitioners agree that debt financing gives rise to tax shelter which enhances the

value of the firm.

Preserve Flexibility

Flexibility implies that the firm maintains reserve borrowing power to enable it to

raise debt capital to respond to unforeseen changes in business and political

environment. Hence the firm must maintain some unused debt capacity as an

insurance against adverse future developments.

Ensure that the Total Risk Exposure is Reasonable

The affairs of the firm should be managed in such a way that the total risk borne by

the equity shareholders is not unduly high.

Subordinate Financial Policy to Corporate Strategy


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Financial policy and corporate strategy are often not integrated well. This may be

because financial

Mitigate Potential Agency Costs.

Due to separate ownership and control in modern corporations, agency problems

arise. Shareholders scattered and dispersed as they are not able to organise

themselves effectively. Hence, very little monitoring takes place in the security

markets.

Since agency costs are borne buy shareholders and the management, the financing

strategy of a firm should seek to minimise these cost by employing external agents

who specialise in low cost monitoring.

Issue innovative Securities

Thanks to SEBI guidelines introduced in 1992, issues have considerable freedom

in designing financial instruments. There is greater scope for employing innovative

securities to the advantage of the firm. The important securities innovations have

been as follows: floating rate bonds (or notes), collateralised mortgage obligations,

dual currency bonds, extendible notes, medium term notes.

Widen the Range of Financing Sources

In as dynamically evolving financial environment, traditional sources of financing

may diminish in importance. They may not be adequate or optimal. Hence, it

behoves on a firm to employ new modes of finance like commercial paper,

factoring, Euro issues, and securitisation.

Capital expenditure: an overview

Factors Of Capex

Organizations engaged in manufacturing and marketing of goods or services

require assets in their operations. An asset can be thought of as any expenditure,which creates or aids in creation of a revenue-generating base. Companies incur


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various expenditure to carry on standard flow of work, expenditure intended to

yield returns over a period of time, and usually exceeding one year is regarded as

capital expenditure. Various factors are considered before Board of Directors

approves any expenditure. All that factors can further be divided into:

Operational Factors

I. To meet future requirements based on market forecast.

II. To maintain coordination with the vision of the company as Ranbaxy

vision Garuda states to be top five generic players in the world by 2012

and achieve sales of 5 billion. To achieve this target company has to

incur heavy expenditure on acquisition of fixed assets.

III. To increase market penetration.

IV. To maintain, renew, expand, upgrade existing physical assets that helps

to facilitate and enhance revenue-generating capacity.

V. To create, acquire and develop revenue generating activities/ capacities

that is imperative for an organizations healthy growth and existence.

Financial Factors

In deciding which assets to create, acquire or develop, the benefits to be gained

from the expenditure have to be weighed against the costs that will be incurred.

While costs can always be expressed in financial terms, the benefits may or may

not be similarly quantifiable. Nevertheless, an attempt must be made to express

the benefits expected, in a manner that facilitates comparison with costs and helps

formulate a rational basis for the decision making process. Following are the

financial tools that are taken into account for approving capital expenditure.

Discounted Cash Flow (DCF)


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This is one of the techniques for financial evaluation of Capexs. DCF techniques

are based on the concept of time value of money and provide a methodology of

taking into account the timing of cash proceeds and outlays over the life of the

investment. The procedure underscores the need to state cash flow streams

arising in different time periods thus differing in value and, hence comparable

only in terms of a common denominator viz. present values.

I. Discounted Payback Period (DPP)

DPP is the number of years it takes for the present value of inflows to equal the

initial investment. Apart from giving due importance to time value of money it

serves as a reasonable tool of risk approximation. It favors projects, which

generate substantial cash inflows in initial years, and discriminates against those

that bring in substantial inflows in later years (risk tending to increase with

tenure). Thereby implying that an early resolution of uncertainty enables the

decision maker to take prompt corrective action by modifying/ changing other

investment decisions.

However, by the same logic it cannot be used as a principal tool for analysis

because it ignores any substantial cash flows arising after the pay back period.

II. Internal Rate of Return (IRR)

IRR is the discount rate that equates the present value of the expected future cash

inflows to the present value of the expected future cash outflows. It is the post tax

return from investment and hence the excess of IRR over the cost of capital

indicates a surplus after paying for the capital employed. IRR presupposes an

equivalent rate of return on the cash flows generated during the life of the asset

i.e., it assumes re-investment of intermediate cash flows at the rate of return equal

to the project's IRR.


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Internal rates of return are most often used as useful additions to NPV

computations. This has in turn justified the use of IRR as a good substitute to

NPV. IRRs have the merit of indicating whether a project is worthwhile, in

that - an IRR above the cost of capital represents a positive NPV project, an IRR

equal to the cost of capital is a zero NPV project and an IRR less than the cost of

capital is associated with a negative NPV project.

Inspite of its merits, it needs to be understood that IRRs helps only to identify

projects that maximizes the ratio of rupee-value to rupee-capital in percentage

terms. What NPV will help in determining is the projects that maximizes the

rupee-spread between value and capital.

III. Net Present Value (NPV)

NPV is equal to the present value of cash inflows minus the present values of

cash outflows. A positive NPV is a prerequisite for the 'acceptance' of the project.

The primary tool of appraisal would be the NPV method. Its superiority overother methods arises out of its principal merit of incorporating all benefits and

costs occurring over the life of the asset

IV. Profitability Index (PI)

The Profitability Index essentially measures the Present value of benefits times

the initial investment. Under unconstrained conditions, the profitability index will

accept and reject the same projects as the NPV criterion.

It is possible that a project may have no critical risks. Or the financial are

extremely favorable (high NPV, high IRR, high PI, low DPP etc.) and the

occurrence of consequent risks may not compromise the success of the project. It

is also possible that there is a conscious corporate decision to accept certain risks.

In such cases, no measures are required. These risks, in any case, must beexplicitly stated in the Quantitative assessment of Risk Capital investments are


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essentially committed in expectation rather than in certainty, which implies that

investments are subject to risk contribute to removing the shortcomings of an

unstructured workings.

INTRODUCTION

The term 'Capital expenditure' refers to expenditure intended to yield returns

over a period of time, usually exceeding one year. This basically implies that any

expenditure, which results in the creation of a new asset or substantially increases

the capacity/benefits of an existing asset and is of a "long term" nature, should be

classified as Capital expenditure.

Since, the expression 'Capital expenditure' is not exhaustively defined, the facts

of a particular case would decide whether expenditure is capital or revenue.

Generally speaking, the expenditure should be tested on the following criteria to

facilitate classification between capital and revenue.

Expenditure would be deemed to be capital, if incurred for

Initiation of business

Extension of business: Entry into new markets & products

(including R&D and regulatory expenses).


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Modification of asset/ equipment resulting in increased benefits

from the existing asset

Bringing into existence a new asset.

Conversely, expenditure would be deemed to be revenue, if

incurred for

Routine repairs and maintenance of existing plant.

Replacement of any part of the existing plant with capacitiesremaining unchanged

Shifting of plants

Making alterations or renovations on rented premises

Assets having life of less than one year

Classification Of Capital Investments

Since the analysis for appraisal of the proposed capital expenditure will largely

depend upon the kind of investment, it is necessary to classify capital investments

into the following categories:

1) Cost Reduction, Modernisation and Rationalisation.

Expenditure to replace serviceable, but obsolete equipment. This may

become necessary because of the expiry of normal life or change in technology.

The purpose of this expenditure is to improve productivity, increase efficiency or

reduce cost of labour, material or other items such as power.

2) Expansion of Existing Products/ Capacity


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Expenditures to increase plant capacity for existing products/equipment or

enhance multi-purpose flexibility.

3) Expansion into New Products/New Product Packs

Expenditure necessary to produce new products/new product pack. This also

includes expenditure on existing facilities to handle new products which may

result in incremental realizations / value additions.

4) New market development and Market Entry

This would include expenditure made for entering and developing new markets.

Such proposals would require the business case to be accompanied with detailedfinancial analysis.

5) Replacement: Maintenance of Business

Expenditure necessary to replace worn-out or damaged equipment. They are not

likely to increase capacity or alter production significantly. Capital spares are

included here.

6) Quality, Good Manufacturing Practices, Safety, Health and Environment.

Expenditures necessary to upgrade quality, compliance of GMPs, government

regulations, labour agreements, insurance policy terms, and environmental safety

requirements. Financial evaluation/benefits from such expenditure may to the

extent quantifiable, be provided.

7) Research & Development

Expenditure on R&D projects/ equipment/ facilities. Financial evaluation/benefits

from such expenditure may to the extent quantifiable, be provided.

8) Information Technology

Expenditure on procurement of IT infrastructure (Hardware) and/or application

software. Financial evaluation/benefits from such expenditure may to the extent

quantifiable, be provided.


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9) Others

This includes office buildings, vehicles, furniture, office equipment, InfoTech

related equipment and utilities, and all such assets, which provide infrastructures

support. This also includes any capital expenditure not explicitly covered in the

above classifications.

Capital Expenditure proposals are not applicable for

1]Employee entitlements

Capital expenditure necessary to meet the commitments in respect of provision of

assets to the employees in terms of personnel policies. Financial evaluation of

such expenditure is not required. Assets purchased by employees against their

hard/soft furnishing entitlements do not fall within the scope of this manual and

hence, will not be included here as they are per policy.

2]Amounts less than Rs.10, 000/ $1,000

Segregation of Capex and Revenue Expenditure

Broadly, the following shall be considered as Revenue:

All repairs to equipment in the normal course of business.

All annual maintenance contracts (AMC) to keep the said equipment/assets in

working condition.

All expenditures, which do not result in an enduring/permanent benefit to the

assets.

Modification to the existing assets, which does not result in enduring benefit,

are to be treated as Revenue after taking ratification of Technical Head of

Plant.


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Piping and insulation of the nature of minor repair or replacement.

Re-arrangement of assets or minor structural changes for regulatory batches.

All accessories / dies & punches which are procured subsequent to purchase of

assets

In case of certain expenditure the treatment of which is in doubt, the decision in

this respect shall be exercised by the Plant Account Manager in consultation with

the User/Technical Head.

Date Of Capitalisation

Date of Capitalisation would be the date when the assets is certified by the

concerned Engineering / E&F Department as ready to use or GRN date in case of

assets which do not need commissioning (that is computers, furniture, fixtures

etc.). Authority for fixing date of capitalisation would be with E&F department.

Lead-time between certification and Commencement of commercial production

will not normally exceeds 30 days

In case of lead-time exceeding 30 days to take specific approvals from the Plant

Head.

Capitalization of Expenditure other than basic cost of assets

All expenditure directly related to the assets capitalized including freight, Entry

tax, Octroi, custom duty, and any such amount, which does not form part of the

original invoice, is to be capitalized along with the relevant assets.

All installation cost, service charges and labour cost, trial run cost (net of

realizable value of the product), technician fee and any other expenditure directly

attributable to the installation.


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Cenvat /CVD credits will be netted off from the cost of assets. As per accounting

standard we have to capitalise the assets net of Modvat.

E&F department operational cost will be directly identified with the projects or

allocated to the projects on equitable basis.

For all this expenditure it is important to book at the stage of initiation at SAP

locations through the same capital internal order number, which has been

uniquely given to the Capex proposal at the time of initiation of the particular

asset.

Regarding Cenvat/ CVD credits netting off, special care is required to be taken

towards year ends to ensure meeting technical requirements as per the

Accounting Standards and ensure maximum depreciation (including higher

depreciation allowed is accounted for on capitalization, as applicable & there is

no Cenvat (cash flow) loss.

Capex Numbering

The numbering scheme is as under

Entity/Division/Cost Center No./ Year/ Serial No. of CEP raised by that

RCC/ Running Serial No. of Capex of the Division/ Plant, to be given by the

Accounts department. In case of Head Office, H.O will appear against division's

name.

At the beginning of the year capital budget prepared by every cost center (RCC) for

the particular year in every business area. This budget prepared every department and

submitted to the division. Then division decided and finalized the budget and given to

the management committee for the final approval. Capital budget is three type

prepared by the company.

Divisional

Study of Capital Structure

Documents

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