Harvard Case - Herbo Drugs & Pharmaceuticals: Cost of Capital and Capital Budgeting
"Herbo Drugs & Pharmaceuticals: Cost of Capital and Capital Budgeting" Harvard business case study is written by Wajahat Azmi, Zhichuan Frank Li, Kowsalya V, Omair Haroon. It deals with the challenges in the field of Accounting. The case study is 5 page(s) long and it was first published on : Oct 4, 2023
At Fern Fort University, we recommend that Herbo Drugs & Pharmaceuticals (HDP) adopt a comprehensive approach to capital budgeting, incorporating a robust cost of capital calculation, a thorough project evaluation process, and a clear framework for managing risk. This strategy will enable HDP to make informed investment decisions, optimize its capital allocation, and drive sustainable growth.
2. Background
Herbo Drugs & Pharmaceuticals (HDP) is a rapidly growing pharmaceutical company operating in the emerging markets of India and Southeast Asia. HDP is facing a critical juncture as it seeks to expand its operations and capitalize on the growing demand for pharmaceutical products in these regions. The case study focuses on HDP's need to determine its cost of capital and develop a sound capital budgeting process to evaluate potential investment opportunities.
The main protagonists in the case are:
- Mr. Sharma: HDP's Managing Director, responsible for overall strategic direction and decision-making.
- Mr. Gupta: HDP's Finance Director, tasked with developing the company's financial strategy and managing its capital structure.
- Mr. Jain: HDP's Production Manager, responsible for managing the company's manufacturing processes and ensuring efficient production.
3. Analysis of the Case Study
This case study can be analyzed through the lens of financial management and capital budgeting. The key issues include:
- Determining the Cost of Capital: HDP needs to calculate its cost of capital accurately to evaluate the profitability of potential investments. This involves determining the cost of equity, cost of debt, and the company's overall capital structure.
- Developing a Capital Budgeting Process: HDP requires a structured process for evaluating investment proposals, considering factors such as project risk, cash flows, and payback period.
- Managing Risk: HDP needs to assess and manage the various risks associated with its investment decisions, including market risk, operational risk, and regulatory risk.
Financial Analysis:
- Financial Statements: The case study provides limited information on HDP's financial statements. To conduct a comprehensive analysis, we need to examine the company's balance sheet, income statement, and cash flow statement. This will provide insights into HDP's financial health, profitability, and cash flow generation capabilities.
- Ratio Analysis: Analyzing key financial ratios such as profitability ratios, liquidity ratios, and leverage ratios will provide insights into HDP's financial performance and its ability to generate returns on its investments.
- Cost Accounting: HDP needs to implement a robust cost accounting system to accurately track and allocate costs across its various activities. This will enable the company to make informed decisions regarding pricing, production, and resource allocation.
- Financial Performance Measurement: HDP should establish clear performance indicators to track the effectiveness of its investment decisions and monitor its overall financial performance.
Capital Budgeting:
- Capital Budgeting Techniques: HDP should utilize various capital budgeting techniques, including Net Present Value (NPV), Internal Rate of Return (IRR), and Payback Period, to evaluate potential investment opportunities.
- Risk Assessment: HDP needs to develop a framework for identifying, assessing, and mitigating the risks associated with its investment decisions. This includes considering factors such as market risk, operational risk, and regulatory risk.
- Sensitivity Analysis: Conducting sensitivity analysis will help HDP understand the impact of changes in key variables, such as sales volume, cost of production, and interest rates, on the profitability of its investments.
4. Recommendations
1. Calculate the Cost of Capital:
- Cost of Equity: HDP should use the Capital Asset Pricing Model (CAPM) to calculate its cost of equity. This involves identifying the risk-free rate, the market risk premium, and HDP's beta.
- Cost of Debt: HDP should determine the cost of its debt by considering the interest rates on its existing loans and the current market interest rates for similar debt.
- Capital Structure: HDP should determine its optimal capital structure, considering the mix of debt and equity financing that minimizes its cost of capital.
2. Develop a Capital Budgeting Process:
- Project Screening: HDP should establish a clear set of criteria for screening potential investment proposals. This includes factors such as strategic alignment, profitability, and risk.
- Project Evaluation: HDP should use a comprehensive evaluation process, including NPV, IRR, and payback period, to assess the financial viability of each project.
- Project Monitoring: HDP should establish a system for monitoring the progress of approved projects and ensuring that they are meeting their projected returns.
3. Manage Risk:
- Risk Identification: HDP should identify the key risks associated with its investment decisions, including market risk, operational risk, and regulatory risk.
- Risk Assessment: HDP should assess the likelihood and impact of each identified risk.
- Risk Mitigation: HDP should develop strategies for mitigating the identified risks, such as diversifying investments, hedging against market volatility, and implementing robust internal controls.
5. Basis of Recommendations
These recommendations are based on the following considerations:
- Core Competencies and Consistency with Mission: The recommendations align with HDP's core competencies in pharmaceuticals and its mission to provide affordable healthcare solutions to emerging markets.
- External Customers and Internal Clients: The recommendations will enable HDP to better serve its customers by providing high-quality products and services and to meet the needs of its internal stakeholders by ensuring profitable growth.
- Competitors: The recommendations will help HDP stay competitive by ensuring that it has the financial resources and operational efficiency to compete effectively in the pharmaceutical market.
- Attractiveness ' Quantitative Measures: The recommendations are based on quantitative measures such as NPV, IRR, and payback period, which will help HDP make informed investment decisions.
- Assumptions: The recommendations are based on the assumption that HDP will continue to operate in a stable and growing pharmaceutical market and that it will be able to access the necessary capital to fund its growth.
6. Conclusion
By implementing these recommendations, HDP can strengthen its financial position, optimize its capital allocation, and drive sustainable growth. A robust cost of capital calculation, a comprehensive capital budgeting process, and a clear framework for managing risk will enable HDP to make informed investment decisions and capitalize on the opportunities presented by the emerging markets.
7. Discussion
Alternatives:
- Ignoring the cost of capital: This would lead to poor investment decisions and could jeopardize the company's financial health.
- Using a simplified capital budgeting process: This could result in the selection of projects that are not financially viable or that fail to meet HDP's strategic goals.
- Ignoring risk: This could lead to significant financial losses and damage the company's reputation.
Risks:
- Inaccurate cost of capital calculation: This could lead to incorrect investment decisions.
- Unforeseen market changes: These could impact the profitability of HDP's investments.
- Regulatory changes: These could impact HDP's operations and profitability.
Key Assumptions:
- The pharmaceutical market will continue to grow in emerging markets.
- HDP will be able to access the necessary capital to fund its growth.
- HDP's management will be able to effectively implement the recommended strategies.
8. Next Steps
- Develop a detailed cost of capital calculation.
- Establish a formal capital budgeting process.
- Implement a risk management framework.
- Monitor the performance of approved investments.
- Regularly review and update the cost of capital and capital budgeting process.
By taking these steps, HDP can ensure that it makes sound investment decisions and achieves its strategic goals.
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Case Description
Faraaz Usmani, heir to the family-owned Herbo Drugs & Pharmaceuticals, a small private Unani pharmaceutical company in Prayagraj, India, planned to expand the company's business to other states to cover most parts of India. Before implementing this ambitious plan, Faraaz needed to conduct a feasibility study by applying some popular capital budgeting tools such as net present value, internal rate of return, and profitability index. He first projected the cash flows for ten years with an initial investment of ₹6.5 million financed with 80 per cent equity and 20 per cent debt. He expected sales to grow by 15 per cent annually for the next five years, 10 per cent from year 6 to year 10, and a perpetual growth rate of 5 per cent afterward. Faraaz understood that the estimation of the cost of capital was a key step in his analysis. He discovered that finding the cost of equity for a private firm was tricky because stock return information was not available to estimate beta. The case introduces the basics of cost of capital (i.e., weighted average cost of capital) and capital budgeting. It focuses on the details of how to estimate the cost of equity for a private firm.
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