Herbo Drugs & Pharmaceuticals: Cost of Capital and Capital Budgeting

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.

The case is targeted at introductory bachelor of business administration and master of business administration students, covering the basics of cost of capital and capital budgeting. The case can be covered in a ninety-minute session. By working through the case and assignment questions, students will have the opportunity to do the following:<br><br><ul><li>Understand the concept of cost of capital.</li><li>Understand the approach of estimating the cost of equity (levered and unlevered) and the cost of debt for an unlisted firm.</li><li>Understand the calculation of weighted average cost of capital, with all the inputs.</li><li>Understand the feasibility study by applying capital budgeting tools (net present value, internal rate of return, and profitability index).</li></ul>

• cost of capital
• weighted average cost of capital
• capital budgeting
• net present value
• cost of equity