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Dr Reddy’s plan to issue bonus debentures signals confidence

Dr Reddy’s plan to issue bonus debentures signals confidence
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First Published: Sun, Apr 04 2010. 09 20 PM IST

Updated: Sun, Apr 04 2010. 09 20 PM IST
Drug maker Dr Reddy’s Laboratories Ltd, or DRL, plans to issue bonus debentures, popularized by consumer goods maker Hindustan Unilever Ltd, to return capital to shareholders. The issue signals DRL’s confidence in its performance and ability to sustain cash flows as well as its desire to improve its return ratios. Firms seek to return capital to shareholders when they have surplus cash. Bonus debentures serve a few other purposes too.
There is no immediate cash outflow as money simply changes character, through a book entry, from reserves to debt. This is unlike buy-backs or dividends where the outflow is immediate. Moreover, there is no uncertainty about the success of the issue unlike a buy-back. Bonus debentures have the immediate effect of improving a company’s return on net worth, lowering its weighted average cost of capital and, after redemption, improving its return on capital employed, too.
Profitability ratios such as return on net worth (RONW) and return on capital employed (ROCE) are computed by dividing the profit (return) by the capital (net worth/capital employed) in the denominator. One way of improving these ratios is to increase profits. Bonus debentures offer an alternative. As a portion of the net worth is converted into debentures, RONW will increase simply because the denominator reduces. When the debentures mature and capital employed falls as a result, ROCE will improve too. Shareholders benefit as these debentures are tax-free and can be sold before redemption.
The issue is a sign of DRL’s confidence in its business plans. Not only is it committing itself to a cash outflow three years hence, but it will also pay interest on these debentures for this period. Assuming an interest rate of about 8%, its annual outflow will be in excess of Rs40 crore. DRL’s performance in fiscal 2010 has seen its net profit get affected by impairment provisions, resulting in a net loss of Rs60 crore for the nine months ended December. But its actual operating performance was good and its cash flow improved too, up at Rs1,142 crore compared with a negative Rs68 crore a year ago. This level of cash flow will suffice to meet its capital expenditure needs. Handing cash back to shareholders is also a signal that the company is not planning any big-ticket acquisition.
What DRL gets in return for its munificence is an improvement in its RONW; at Rs520 crore the issue will take away about 13% of its net worth as of 31 December. When these debentures will be redeemed after three years in fiscal 2014, its ROCE, too, will get a boost. DRL has a target of achieving 25% ROCE by fiscal 2013. These debentures will do their bit to help maintain this ratio afterwards too.
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First Published: Sun, Apr 04 2010. 09 20 PM IST