A
Project 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
 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
Page No.
 Board of Directors
 Strategic Business Units
 Key Milestones
 Department
IV.
V.
VI.
Capital Budgeting
Findings and Suggestions
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
Intermediates
Drug Discovery
&
Development
API
Finished Dosages
Branded
Generics
(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.”
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”.
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 issuing
opinion on the financial statements prepared under the US GAAP.
INERNATIONAL MARKET AREAS OF DR. REDDY’S LABORATORIES
Belarus
Cambodia
China
Dmpr
Ghana
Guyana
Haiti
Iraq
Jamaica
Kenya
Kyrgyzstan
Malaysia
Mauritius
Myanmar
Oman
Romania
Russia
Singapore
Sri Lanka
St.Kitts
St.lucia
Sudan
Tanzania
Trinidad
Uganda
Ukraine
Uzbekistan
Venezuela
Vietnam
Yemen
Albania
Cayman islands
Kazakhstan
SHARE CAPTIAL:
(Rs in Thousands)
PARTICULARS
Equity
Debt-long Term
Total Share Capital
2004-05 2005-06
2006-2007
2007-08
479827
501114
964692
1176665
576
471085
414604
321604
480403
972199
1379296
1498269
1200000
1000000
800000
Equity
600000
Debt
400000
200000
0
2004
2005
2006
2007
Graph 1:
Source
CURRENT FINANCIAL POSITION OF DR.REDDY’S LAB
Shareholding Pattern on May 29, 2009
No. Of Shares
Promoters Holding:
% of Shares
Individual Holding
4,489,484
2.66
Companies
39,978,328
23.73
Sub Total
Indian Financial Institutions
44,467,812
22,524,568
13.37
312,746
0.19
10,764,293
6.39
33,601,607
19.95
38,985,964
23.14
NRIs
3,097,432
1.84
ADRs / Foreign National
24,903,193
14.78
66,986,589
39.76
Indian Public & Corporates
23,412,769
13.90
Total
168,468,777
100.00
Banks
Mutual Funds
Sub Total
Foreign Holding:
Foreign Institutional
Investors
Sub Total
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
($158 million), representing a growth of 5%.
4) 36 new products launched during the year.
5) New products launched in the last 36 months contribute 14% to total revenues in FY09
Dr. Reddy’s
Extracted from the Audited Income Statement for the year ended March 31,
2009
FY 09
Particulars
Revenues
($)
(Rs.)
FY 08
(Rs.)
(%)
Growth
%
%
($)
1,365 69,441 100
983
50,006 100
39
Cost of revenues
648
32,941
47
484
24,598 49
34
Gross profit
718
36,500
53
499
25,408 51
44
Selling, General &
Administrative Expenses(a)
413
21,020
30
331
16,835 34
25
Research & Development
Expenses, net
79
4,037
6
69
3,533
7
14
Write down of intangible assets
62
3,167
5
59
3,011
6
5
Write down of goodwill
213
10,856
16
2
90
0
-
5
253
0
(8)
(402)
(1)
-
Total Operating Expenses
773
39,333
57
453
23,067 46
Results from operating
(56) (2,833) (4)
46
2,341
Operating Expenses
Other (income)/expenses, net
5
71
-
activities
Finance Income(b)
(9)
(482)
(1)
Finance expenses(c)
33
1,668
2
21
1,080
2
54
Finance expenses, net
23
1,186
2
(10)
(521)
(1)
-
Share of profit/ (loss) of equity
accounted investees
0
24
0
0
2
0
1,100
(31) (1,601) (3)
(70)
Profit before income tax
(79) (3,995) (6)
56
2,864
6
-
Income tax expense
(23) (1,173) (2)
19
972
2
-
Profit for the period
(102) (5,168) (7)
75
3,836
8
-
(102) (5,168) (7)
76
3,846
8
-
(0)
(10)
(0)
-
75
3,836
8
-
Attributable to:
Equity holders of the company
Minority interest
0
Profit for the period
0
(102) (5,168) (7)
Weighted average no. of
shares o/s
Diluted EPS
0
169
(0.6)
Exchange rate
169
(30.7)
0.4
50.87
22.8
50.87
Notes:
(a)
Includes amortization charges of Rs. 1,503 million in FY09 and Rs. 1,588
million in FY08
(b)
Includes forex gain of Rs. 739 million in FY08
(c)
Includes forex loss of Rs. 634 million in FY09.
(In millions)Key Balance Sheet Items
Particulars
As on 31st Mar 09 As on 31st Mar 08
($)
(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 2007
2nd 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—nondiscounting 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:
Evaluation Criteria
Non- Discounting Criteria
Payback
Period
Accounting Rate
of Return
(ARR)
Discounting Criteria
Profitability
Index
(PI)
Internal
Rate of
Return
(IRR)
Net Present
Value
(NPV)
Annual
Capital
Charge
Comparing Methods of Valuation under Various Scenarios
Method
Independent
Projects
Mutually Exclusive *Capital
Projects
Rationing
IRR
Acceptable
Not Acceptable
Not Acceptable Not Acceptable
MIRR
Acceptable
Not Acceptable
Not Acceptable Not Acceptable
NPV
Acceptable
Acceptable
Acceptable
*Scale Differences
Acceptable
Payback
Not Acceptable Not Acceptable
Not Acceptable Not Acceptable
Discounted 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
Year 1
3,000
Year 2
3,500
Year 3
3,500
Year 4
1,500
Year 5
1,500
Year 6
3,000
Payback
Period
Cumulative
Cash Inflows
of Project A
3,000
6,500
10,000
11,000
13,000
16,000
3 years
Project B
2,000
2,500
2,500
2,500
3,000
5,500
Cumulative
Cash
Inflows of
Project B
2,000
4,500
7,000
9,500
12,500
18,000
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, shortterm 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:
(Rs. Per Unit)
Contract Manufacturing
Type of Vial
Equivalent Injection
USD
CC
CC (In Rs)
Freight
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
Royalty
(Rs)
-
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
Type of Vial
Equivalent
Injection
(Rs. per Unit)
CC
Depreciation
Freight Total
CC
Savings
Non Lyophilised
Zoledronic Acid –
Liq
Lyophilised
Amifostin – Lyo
Prefilled Syringes
Enoxaparin Na
Cost incurred would be:
5.18
-
10.00
15.18
24.82
5.18
-
10.00
15.18
34.82
5.18
-
10.00
15.18
14.82
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.
Type of Vial LL Location Equivalent Injection
USD CC CC (In Rs) Frieght Royalty (Rs)
Equivalent Injection
60
50
Prices
40
30
20
10
0
Liquid
Lypo
Pfs
40
50
30
manu. Cost
15.18
15.18
15.18
savings
24.82
34.82
14.82
contract price
For manufacturing the product the following assets are required:
Project Cost of Non Cyto Injectables & Prefilled Syringes
Description
Amount (Ph 1)
Amount (Ph 2)
(Rs. In Lakhs)
Class of Asset
Civil
Partitions
HVAC
Equipments
Mechanical
Electrical
Utility
Validation
Instruments - QC
Revenue
Revenue – QC
Consultant Fees
Contingency
1,112
500
400
2,410
200
270
125
70
100
100
20
150
250
100
654
30
10
Total
5,707
824
Buildings
Buildings
Plant & Mach
Plant & Mach
Plant & Mach
Electrical Equip
Plant & Mach
Plant & Mach
Lab Equip
Buildings
Lab Equip
Buildings
Plant & Mach
30
Depreciation of Non Cyto Injectables
Depreciation is calculated on Straight Line Method
(Rs. In Millions)
Phase 1
Class
Buildings
Plant & Mach
Electrical
Equip
Lab Equip
Total
Policy
(Life in
Years)
Life
20 to 50
Phase 2
Amount
Dep
per
year
Amount
35
186.24
5.32
10.00
0.29
3 to 15
9
345.50
38.39
72.40
8.04
5 to 15
10
27.00
2.70
-
-
5 to 15
10
12.00
1.20
-
-
570.74
47.61
82.40
Total Depreciation for the assets as per their phases:
Dep per
year
8.33
Year
FY 09
FY 10
FY 11
FY 12
FY 13
FY 14
FY 15
FY 16
FY 17
Total
47.61
47.61
47.61
47.61
47.61
47.61
47.61
333.27
8.33
8.33
8.33
8.33
8.33
41.65
55.94
55.94
55.94
55.94
55.94
374.92
Dep. in Year (Phase 1)
Dep. in Year (Phase 2)
Total Dep. ( in Mln
Rs)
-
-
47.61
47.61
Conversion Cost at Manufacture is as follows:
( The Actual Total cost of the product i.e, The Cost Sheet)
Actual Material – Imported
Actual Material – India
Actual Packing – Imported
Actual Packing – India
Actual Input Taxes
Actual Landed cost
Actual Subcontractor
Actual Material
Actual Direct Depreciation
Actual Direct Manpower
Actual ETF
Actual HVAC
Actual Maintenance
Actual Other Direct
Actual Other Utility
Actual Power
Actual Quantity
Actual Steams
Actual Overhead
Actual Total Cost
0.07
1.53
2.45
3.57
0.33
0.20
0.00
8.15
0.94
0.59
0.08
0.13
0.85
0.28
0.14
0.08
0.12
0.00
3.21
11.36
Non Cyto Injectables Project – CC Projection
Manpower Cost Computation
No. Of people
Average salary per
head
Payroll Cost p.a.
100
50 per shift * 2 Shifts
Production
Manpower cost per
unit
18,000,000
250,000
25,000,000
Average annual production from fy 11 to fy
17
1.39
Summary of Conversion Cost
Cost Component
Manpower Cost
FY
11
1.39
FY
12
1.50
FY
13
1.62
FY
14
1.75
FY
15
1.89
FY
16
2.04
FY
17
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
5.87
4.49
4.51
4.50
4.74
4.98
7.14
Manpower Cost – 8% increment year over year
Utility Cost – 5% inflation year over year
Cost of freight per Vial
Fill Liquid Weight
Bottle weight
Shippers weight
Total weight per vial
15
20
15
50
Weight per vial
Grams
Grams
Grams
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
Year
Outflow
1
2
Inflow
Liquid
Vials
260.37
4
6
7
8
9
10
Lypo
Vials
260.37
3
5
Tax
57.40
PFS
SEZ
Net In
Flow
DCF @
0%
Discounted
In flow
Cum
Discntd In
flow
-
(260.37)
1.00
(260.37)
(260.37)
(260.37)
1.00
(260.37)
(520.74)
-
-
-
-
-
-
-
1.00
-
(520.74)
143.88
2.45
11.75
158.09
1.00
158.09
(362.65)
183.42
7.50
15.93
149.46
1.00
149.46
(213.19)
225.06
18.95
26.94
270.95
1.00
270.95
57.76
258.27
24.12
33.25
315.65
1.00
315.65
373.41
397.02
66.60
53.43
517.05
1.00
517.05
890.45
416.89
70.72
28.03
515.64
1.00
515.64
1,406.09
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
In
flow
Year
In flow
In flow
Rs.
Outflow Rs. Mn on Rs. Mn on Mn on
Rs. Mn
NonLypo
Lypo
PFS
0
25.00
1
25.00
2
3
1.00
4
25.00
9.20
5
100.04
6
143.67
7
219.42
8
228.88
9
Net In
DCF
Flow
@
0%
(25.00)
1.00
(25.00)
1.00
1.00
1.00
1.00
(15.80)
1.00
100.04
1.00
143.67
1.00
219.42
1.00
228.88
1.00
238.58
238.58
1.00
Discntd
In flow
(25.00)
(25.00)
1.00
(15.80)
100.04
143.67
219.42
228.88
238.58
Cum
Discntd
In flow
(25.00)
(50.00)
(50.00)
(49.00)
(64.80)
35.24
178.91
398.33
627.21
865.79
Payback is 5 Years 2
Months
Total Project - Payback period computation
Outflow
Year
Project
Cost
Inflow
Liquid
Vials
1
Tax
Lypo
Vials
PFS
SEZ
-
-
-
-
-
-
-
-
-
-
-
-
285.37
2
285.37
3
Net In
Flow
DCF @
0%
Discntd
In flow
Cum
Discntd In
flow
(285.37)
1.00
(285.37)
(285.37)
(285.37)
-
1.00
(285.37)
-
(570.74)
1.00
(570.74)
4
143.88
2.45
1.00
11.75
159.09
1.00
159.09
(411.65)
183.42
7.50
9.20
15.93
133.66
1.00
133.66
(277.99)
225.06
18.95
100.04
26.94
370.98
1.00
370.98
93.00
258.27
24.12
143.67
33.25
459.32
1.00
459.32
552.31
397.02
66.60
219.42
53.43
736.47
1.00
736.47
1,288.78
416.89
70.72
228.88
28.03
744.51
1.00
744.51
2,033.30
437.36
74.24
238.58
29.35
779.54
1.00
779.54
2,812.83
5
82.40
6
7
8
9
10
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
Inflows
Tax
Lypo Vials PFS
SEZ
Outflow
Year
Project
Cost
Net Inflows
DCF
@
14%
Liquid
Vials
Discounted
Inflow
1
285.37
-
-
-
-
(285.37)
1.00
(285.37)
285.37
-
-
-
-
(285.37)
0.88
(250.32)
-
-
-
-
-
0.77
-
143.88
2.45
1.00
11.75
159.09
0.67
107.38
183.42
7.50
9.20
15.93
133.66
0.59
79.14
-
225.06
18.95
100.04
26.94
370.98
0.52
192.68
-
258.27
24.12
143.67
33.25
459.32
0.46
209.26
-
397.02
66.60
219.42
53.43
736.47
0.40
294.32
-
416.89
70.72
228.88
28.03
744.51
0.35
261.00
-
437.36
74.24
238.58
29.35
779.54
0.31
239.71
2
3
-
4
5
82.40
6
7
8
9
10
NPV of the CC Savings
194.65
CC Savings - Total Project - IRR computation
Outflow
Inflows
Project
Cost
Year
Liquid
Vials
Tax
Lypo
Vials
PFS
SEZ
Net In
Flow
DCF
Discntd In
flow
1
285.37
-
-
-
-
(285.37)
1.00
(285.37)
285.37
-
-
-
-
(285.37)
0.75
(213.19)
-
-
-
-
-
-
0.56
-
-
143.88
2.45
1.00
11.75
159.09
0.42
66.33
82.40
183.42
7.50
9.20
15.93
133.66
0.31
41.64
-
225.06
18.95
100.04
26.94
370.98
0.23
86.33
-
258.27
24.12
143.67
33.25
459.32
0.17
79.85
-
397.02
66.60
219.42
53.43
736.47
0.13
95.65
-
416.89
70.72
228.88
28.03
744.51
0.10
72.24
2
3
4
5
6
7
8
9
10
-
437.36
74.24
238.58
NPV of CC savings
0%
IRR of CC savings
34%
29.35
779.54
0.07
56.51
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
Yes
Well, cause we get our money back
years
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