STUDY OF CAPITAL STRUCTURE

FOR

A DISSERTATION PROJECT ON

Ranbaxy Laboratories Ltd.

SUBMITTED TO

MAHENDRA
INSTITUTE OF MANAGEMENT AND TECHNICAL STUDIES IN PARTIAL FULFILLMENT OF THE REQUIREMENT OF TWO YEAR FULL TIME POST GRADUATE DIPLOMA IN MANAGEMENT SUBMITTED BY

SANDIP KUMAR PATTANAIK ROLL NO: PGDM/12-13/207

UNDER THE SUPERVISION OF

Faculty Supervisor Name: Sangram Keshari Panda Assistant Professor Finance

Table of contents
Declaration Acknowledgement Abstract INTRODUCTION TO RANBAXY LABORATORIES LTD Company Profile Vision Operating Joint Ventures and Subsidies Objectives 07-08 09-10 11 12 04 05 06-

INTRODUCTION TO CAPITAL STRUCTURE THEORY AND ANALYSIS Introduction Literature of review on Capital Structure Methodology Theory and Analysis Capital expenditure: an overview Latest balance sheet and capital structure of Ranbaxy Conclusion Biblography 13-14 15 16 17-38 38-41 41-43 44 45

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Declaration
I, Mr. Sandip kumar pattanaik bearing enrolment number PGDM/11-13/207 do hereby declare that this project report titled
SPECIAL REFERANCE TO A STUDY ON STUDY OF CAPITAL STRUCTURE, has

Ranbaxy Laboratories Ltd.

been prepared on the basis of

my learning through Dissertation Programme under the supervision of Prof. Sangram Keshari Panda .The findings of the study are original and the study materials used have been duly recognized in the body of the report. This report has not been submitted to any Institute/University for the award of any degree or diploma in full or part.

Sandip kumar pattanaik Roll No: PGDM/1113/207

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Acknowledgements
With all humility I would like to express that I was very lucky to undergo through this Dissertation Programme. It was a golden opportunity for gaining experience and self development. Further, I am honored to have so many wonderful people who helped me insistently in several ways for the completion of this project report. I sincerely acknowledge my gratitude to Prof. Sangram Keshari Panda who was not only involved in the entire process but also shared his knowledge, encouraged me and gone through the report before it was submitted for evaluation. Without his active support and supervision it was not possible to complete the project work. Thank you, Sir. I would like to thank Dr. Ananta Kumar Roy Director, Dr. Abhijit Dutta Dean, for their active support and arrangements to make my learning and life easier at MIMTS. All my friends deserve thanks for their cooperation and sharing of valuable information that helped me in the preparation of this report. Last but not least I owe my heartfelt gratitude to my parents for their constant help, encouragement and emotional support during the period of Dissertation without which this report would not have been completed. Sandip kumar pattanaik

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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 that , 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 MARCH 1962, 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
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advantage and skilled manpower, while delivering international quality. 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 of the companys human assets and their intensive competitive and entrepreneurial energy 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
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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

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OPERATING JOINT AND SUBSIDIARIES

BRAZIL CHINA EGYPT GERMANY HONG KONG INDIA : : : : : :

VENTURES

Ranbaxy S.P. Medicamentos Ltd. Ranbaxy (Guangzhou China) Ltd. Ranbaxy Egypt Ltd. Basics Gmb H. Ranbaxy (Hong Kong) Ltd. Rexcel pharmaceuticals Ltd., Solus pharmaceuticals Ltd., Vidyut Travel Services ltd.

IRELAND MALAYSIA NETHERLANDS NIGERIA PANAMA POLAND SOUTH AFRICA THAILAND

: : : : : : : :

Ranbaxy Ireland Ltd. Ranbaxy (Malaysia) Sdn. Bhd. Ranbaxy Pharmaceuticals B.V. Ranbaxy Nigeria Ltd. Ranbaxy Panama SA. Ranbaxy Poland Sp. Zo. Ranbaxy (SA) (Pty.) Ltd. Unichem pharmaceuticals LTD., Unichem Distributors Ltd. Part,

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Ranbaxy Unichem CO.Ltd. U.K USA : : Ranbaxy (UK) Ltd Ranbaxy pharmaceuticals Inc. Ohm Laboratories Inc., Ranbaxy Schein Pharma, LLC VIETNAM : Ranbaxy Vietnam Company Ltd.

OBJECTIVES 1. 2. 3. 4. 5. 6.

OF

RANBAXY

LABORATORIES

LTD.

To be a leader in the Pharmaceutical industry. To be a profitable company with a steady growth in earnings. To set an example as a socially responsible company. To diversify in health care related areas. To strive for excellence and continuous improvement in all spheres. To improve the quality of life of people by providing better services and quality products.

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INTRODUCTION TO CAPITAL STRUCTURE THEORY AND ANALYSIS

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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. Limitations of the financial tools used.

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Literature of review on capital structure

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 debt level 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.

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Methodology
The methodology adopted for the study was as follows: 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.

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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 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 capital may 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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Total Capital

Equity Capital

Debt Capital

Equity Share Capital Preference Share Capital Share Premium Retained Earnings

Term Loans Debentures Deferred Payments Liabilities Other Long term Debt

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.

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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. 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 = Contribution EBIT

Contribution = Sales Variable Costs

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EBIT = Earnings Before Interest and Taxes. 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 higher EBIT resulting in higher EPS, if other things remain constant. Financial leverage affects the variability and expected level of EPS. The more debt the firm employs the higher its financial leverage. Financial leverage generally raises expected EPS, but it also increases the riskiness of securities as the debt / asset ratio rises. Financial Leverage =
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EBIT EBT

EBIT Earnings Before Interest and Tax EBT Earnings Before Taxes. Consider Two Hypothetical Firms

Firm U

Firm L No debt 20,000 in assets 40% tax rate 10,000 of 12% debt 20,000 in assets 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 Rs000) EBIT Interest EBT Taxes (40%) NI ROE 3,000 0 3,000 1, 200 1,800 9.0% Firm L 3,000 1,200 1,800 720 1,080 10.8% (Fig. in

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.
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 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 Rs000) (Fig. in

Bad Prob. EBIT Interest EBT Taxes (40%) NI Firm L: Leveraged 0.25 2,000 0 2,000 800 1,200

Avg. 0.50 3,000 0 3,000 1,200 1,800

Good 0.25 4,000 0 4,000 1,600 2,400

Economy (Fig. in Rs000) Bad Avg. Good

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Prob.* EBIT* Interest EBT Taxes (40%) NI *Same as for Firm U. Firm U BEP ROIC ROE TIE Firm L BEP ROIC ROE TIE

0.25 2,000 1,200 800 320 480

0.50 3,000 1,200 1,800 720 1,080

0.25 4,000 1,200 2,800 1,120 1,680

Bad 10.0% 6.0% 6.0% n.a. Bad 10.0% 6.0% 4.8% 1.7x

Avg. 15.0% 9.0% 9.0% n.a. Avg.

Good 20.0% 12.0% 12.0% n.a.

Good 15.0% 20.0% 9.0% 12.0% 10.8% 16.8% 2.5x 3.3x

Profitability Measures: E(BEP) 15.0% E(ROIC) 9.0% E(ROE) Risk Measures: sROIC sROE

15.0% 9.0% 9.0% 2.12% 2.12%

10.8% 2.12% 4.24%

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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. 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.
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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 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 0% 20% 30%
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rd 8.0% 8.5%

40% 50%

10.0% 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. 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 0% 20% 30% 0.00 0.25 0.43 D/S 1.00 1.16 1.28 bL 12.00% 12.98% 13.67% rs

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40% 50%

0.67 1.00

1.43 1.65

14.60% 15.90%

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 0% 20% 30% 40% 50% V = FCF / (WACC-g) g=0, so investment in capital is zero; so FCF = NOPAT = EBIT (1T). NOPAT = (Rs.37,273,800)(1-0.35) = Rs.24,227,970 V = Rs.24,227,970/ 0.1142 = Rs.212,153,852.89 rd 0.0% 8.0% 8.5% 10.0% 12.0% rs 12.00% 12.98% 13.67% 14.60% 15.90% WACC 12.00% 11.42% 11.23% 11.36% 11.85%

Corporate Value for wd = 20%

Corporate Value vs. Leverage wd

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WACC

Corp. Value

0% 20% 30% 40% 50%

12.00% 11.42% 11.23% 11.36% 11.85%

Rs.201,899,750.00 Rs.212,153,852.89 Rs.215,791,315.97 Rs.213,274,383.80 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=VD 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, Rs.169,723,082.31 30% Rs.64, Rs.151,053,921.18 40% Rs.85, Rs.127,964,630.28 50% Rs.102, Rs.102,227,721.52 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.
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430,770.58 737,394.79 309,753.52 227,721.52

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. 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 wd Remaining P # shares Repurch.

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0% 20% 30% 40% 50% wd = 30% gives:

Rs.89.51 0 Rs.94.06 451,116 Rs.95.67 676,673 Rs.94.55 902,231 Rs.90.64 1,127,789

2,255,578 1,804,462 1,578,905 1,353,347 1,127,789

Optimal Capital Structure 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 proponents Modigliani 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 The MM 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. Firms exist with the same business or systematic risk at different levels of gearing. The stock markets are perfectly competitive.
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 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 equity shareholders 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.

Cost of Capital

Cost of Equity

Average cost of Capital

Cost of Debt

Figure 1: MM view of Capital Structure

Level of leverage

In MM theory the following notations will be used: 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.
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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 Vg = Vu = Earnings in ungeared company Ku WACC is independent of the debt / equity ratio and equal to the cost of capital which the firm 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 0.01CFt 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.
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 Cash Flows each period? Int)]=0.01CFt.

[0.01(Int)+0.01(CFt-

As the inherent risk of the firm is the same, then the discounted value of the cash flows must be the same,

WACC

Prop. I

M&M

Traditional

B E E

M M Theory: Proposition II The rate of return required by shareholders increases linearly as the debt / equity ratio is increased 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. MM went 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 the difference between the cost of equity for ungeared company and risk free cost of debt. The cost of equity depends on the following three variables:

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1. The required rate of return on the firm (Ku). 2. The required rate of return on the firms debt (K d). 3. The firms debt/equity ratio (D/E)

Kg = Ku +

D (K Kd ) Vg u

MM proposition II can be summed up in following points: Equity holders require a premium over what everyone is paid if the firm has debt. The premium DOES depend 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. Stockholders are indifferent to capital structure and to change in leverage.
RE

Prop. II
M&M Slope = RA RD

RA

Traditional

B E

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
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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 sold for different values, then shareholders would move from over valued firm to the under 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 in MM 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. MM has 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 Vu.
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Suppose firm changes capital structure by issuing debt and retiring some equity. The firm will realize gain since interest payments on debt are tax-deductible, so tax liability will decline! For perpetual debt: Yearly Tax Savings (Tax Shield) = Interest TC = r D TC = RD B TC 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

VL

Slope = TC

PV of Tax Shield

VU

M&M Value

MM Theory: Corporate Taxation 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:
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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 lower WACC, which falls continuously as gearing increases. 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 PV of Bankruptcy Cost BC = Anticipated costs of bankrupting

PV of Tax Shield VU
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Cost of Debt

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 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
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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.

Capital overview
Factors Of Capex

expenditure:

an

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 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
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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.

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
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 Extension of business: Entry into new markets & products (including R&D and regulatory expenses). 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. 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 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
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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 detailed financial 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.

Balance sheet
Balance Sheet of Ranbaxy Laboratories Dec '12 Sources Of Funds Total Share Capital 211.46 Equity Share Capital 211.46 Share Application Money 1.11 Preference Share Capital 0 1,709.5 Reserves 1 Revaluation Reserves 0 1,922.0 Networth 8 Secured Loans 944.18 Unsecured 3,819.4 Loans 3 4,763.6 Total Debt 1 Total 6,685.6 Liabilities 9 Dec '11 Dec '10 Dec '09 Dec '08 Dec '07 (Rs in Cror) Dec '06 Dec '05 Dec '04 Dec '03

211 211 0.67 0 1,713.1 6 0 1,924.8 3 229.59 4,103.9 4 4,333.5 3 6,258.3 6

210.52 210.52 6.6 0 4,915.2 8 0 5,132.4 0 195.39 4,065.3 3 4,260.7 2 9,393.1 2

210.21 210.21 175.85 0 3,748.5 4 0 4,134.6 0 175.83 3,172.5 5 3,348.3 8 7,482.9 8

210.19 210.19 175.66 0 3,330.9 2 0 3,716.7 7 162.07 3,563.3 0 3,725.3 7 7,442.1 4

186.54 186.54 1.18 0 2,350.68 0 2,538.40 365.07 3,137.96 3,503.03 6,041.43

186.34 186.34 0.88 0 2,162.79 0 2,350.01 224.29 2,954.31 3,178.60 5,528.61

186.22 186.22 0.28 0 2,190.80 0 2,377.30 353.49 676.31 1,029.80 3,407.10

185.89 185.89 2.83 0 2,320.79 0 2,509.51 133.37 2.49 135.86 2,645.37

185.54 185.54 1.99 0 2,134.24 0 2,321.77 30.49 3.76 34.25 2,356.02

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Dec '12 Application Of Funds 3,118.2 Gross Block 2 Less: Accum. 1,124.6 Depreciation 9 1,993.5 Net Block 3 Capital Work in Progress 159.6 3,131.1 Investments 7 1,731.8 Inventories 4 Sundry 1,435.8 Debtors 9 Cash and 2,834.7 Bank Balance 7 Total Current 6,002.5 Assets 0 Loans and 1,683.1 Advances 4 Fixed Deposits 0 Total CA, Loans & 7,685.6 Advances 4 Deffered Credit 0 Current 3,227.2 Liabilities 4 3,057.0 Provisions 2 Total CL & 6,284.2 Provisions 6 Net Current 1,401.3 Assets 8 Miscellaneou s Expenses 0 6,685.6 Total Assets 8

Dec '11 3,094.0 7 1,222.0 7 1,872.0 0 222.62 3,410.7 9 1,655.2 3 3,689.9 5 66.9 5,412.0 8 2,382.7 2 1,871.1 4 9,665.9 4 0 5,157.6 8 3,755.3 1 8,912.9 9 752.95 0 6,258.3 6

Dec '10 2,857.6 3 1,145.5 2 1,712.1 1 330.18 3,804.4 4 1,489.9 1 1,292.6 3 22.44 2,804.9 8 1,470.4 5 2,689.8 5 6,965.2 8 0 2,491.0 8 927.82 3,418.9 0 3,546.3 8 0 9,393.1 1

Dec '09 2,620.9 2 1,027.5 2 1,593.4 0 414.92 3,833.6 9 1,230.4 8 1,534.6 5 25.56 2,790.6 9 1,967.6 5 728.56 5,486.9 0 0 3,082.8 9 763.03 3,845.9 2 1,640.9 8 0 7,482.9 9

Dec '08 2,386.7 5 930.07 1,456.6 8 428.77 3,618.0 3 1,198.5 2 1,024.5 4 49.86 2,272.9 2 2,351.9 8 1,885.0 8 6,509.9 8 0 3,840.1 1 731.2 4,571.3 1 1,938.6 7 0 7,442.1 5

Dec '07

Dec '06

Dec '05

Dec '04

Dec '03

2,261.48 791.96 1,469.52 327.42 3,237.55 976.07 882.91 69.38 1,928.36 882.99 111.07 2,922.42 0 1,177.35 738.14 1,915.49 1,006.93 0 6,041.42

2,133.57 699.54 1,434.03 301.88 2,679.95 954.91 1,013.75 27.06 1,995.72 581.18 44.09 2,620.99 0 985.57 522.67 1,508.24 1,112.75 0 5,528.61

1,799.32 599.35 1,199.97 432.84 762.78 890.93 806.62 30.48 1,728.03 594.94 86.11 2,409.08 0 983.57 413.99 1,397.56 1,011.52 0 3,407.11

1,402.79 525.21 877.58 264.16 679.07 896.34 784.69 37.14 1,718.17 648.61 0.13 2,366.91 0 1,011.53 530.8 1,542.33 824.58 0 2,645.39

1,141.79 435.27 706.52 84.27 337.5 704.73 482.94 17.38 1,205.05 1,185.23 81.15 2,471.43 0 728.24 515.45 1,243.69 1,227.74 0 2,356.03

Capital structure
Ranbaxy Laboratories Capital Structure Period From 2012 2011 2010 2009 2008 2007 To 2012 2011 2010 2009 2008 2007 Equity Share Equity Share Equity Share Equity Share Equity Share Equity Share Instrument --- CAPITAL (Rs. cr) --Authorised 299 299 299 299 299 299 Issued 211.46 211 210.52 210.21 210.18 186.54 -PAIDUPShares (nos) 422913803 421999724 421040693 420417358 420369753 373070829 Face Value 5 5 5 5 5 5 Capital 211.46 211 210.52 210.21 210.18 186.54

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2006 2005 2004 2003 2002

2006 2005 2004 2003 2002

Equity Share Equity Share Equity Share Equity Share Equity Share

299 299 199 199 199

186.34 186.22 185.89 185.54 185.45

372686964 372442190 185890742 185543625 185452098

5 5 10 10 10

186.34 186.22 185.89 185.54 185.45

Capital Structure Ratios

Ranbaxy Laboratories Capital Structure Ratios
Liquidity And Solvency Ratios 2012 Current Ratio Quick Ratio Debt Equity Ratio Long Term Debt Equity Ratio Interest Cover Total Debt to Owners Fund Financial Charges Coverage Ratio Financial Charges Coverage Ratio Post Tax 1.5 1.13 1.19 1.19 5.85 1.19 6.9 5.09 2011 0.9 0.95 1.57 0.5 20.29 1.57 25.53 31.52 2010 1.63 1.56 0.78 0.56 24.88 0.78 33.89 34.39 2009 1.38 1.01 0.87 0.74 8.42 0.87 12.19 8.94 2008 1.35 0.93 1.05 0.81 2.37 1.05 3.75 -2.25 2007 1.29 1.18 1.49 1.09 4.11 1.49 5.67 8.04 2006 1.38 1.29 1.54 1.13 7.03 1.54 8.83 7.73 2005 1.15 1.11 0.82 0.29 2.34 0.82 4.54 7.1 2004 1.43 1.01 0.34 0.15 26.66 0.34 30.41 25.6

Debt Coverage Ratios

MAJOR FINDINGS

CONCLUSION
The successful strategy for Ranbaxy Laboratories Ltd. in a post 2010 world will include: (a)Attain right product-mix (b) Augment skills (c)Use M&A options for either companies or products. (d) Building Innovation Engine at R&D
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(e)Sustain growth momementum in USA. (f) Attain critical mass in Europe and Latin America. (g) (h) Specialty products focus for Brand marketing. Fortifying home business leverage India Base.

(i) Seeding the Japanese market. (j) Networking, licensing and acquisitions. (k) Technology, new market entry vehicles, brands/ proprietary products (l) Global talent pool to fuel growth. The increasing importance of biotech industry and its symbiotic relationship to pharma will also be very relevant in Ranbaxys strategy. However Ranbaxy should not close its eyes on the ever increasing Global competition, which is a big threat for the company. The entry of international and new domestic players would intensify the competition significantly. Further there is threat from other low cost countries like China and Israel. However, on the quality front, India is better placed relative to China. So, differentiation in the contract manufacturing side may wane. The short-term threat for the pharma industry is the uncertainty regarding the implementation of VAT. Though this is likely to have a negative impact in the short-term, the implications over the long-term are positive for the industry.

Bibliography
WEBSITES:-

- www.ranbaxy.com
ONLINE JOURNALS:- Cygnus Business Consulting & Research Indian Pharmaceutical Industry-Oct-Dec 2008
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- FICCI Report for National Competitiveness Council (NMCC) BOOKS:- Financial Management (ICFAI University) - Financial Management (Fourth edition) By M.Y.Khan & P.K.Jain

manufacturing

(Tata McGraw Hill Publishing Company Ltd.) - Financial Management (Sixth edition) By Prasanna Chandra (Tata McGraw Hill Publishing Company Ltd.) - Financial Management (Fourth edition) By Ravi M Kishore

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