American Home Products Corporation Essay

1. How much business endangerment does American kinfolk Products pose? How much monetary risk would American Home Products face at distributively of the proposed levels of debt shown in case Exhibit 3? How much potential value, if any can American Home Products take in for its sh areholders at each of the proposed levels of debt? A combination of business risk and financial risk shows the risk of an organizations future return on law. Business risk is related to make a solids operation without any debt, whereas financial risk requires that the firms coarse extendholders make a purpose to finance it with debt. a) American Home Products has been operating(a) on four main lines of business that are less hesitation about product demand for example, one of its business lines is food products beca utilisation whenever mess buy foods. It means that AHPs business risk is low. As mentioned above, if a firm does its operation activities regularly without leverage, it means that i ts business risk is not significant high. Thus, ratio of transmute to come up assets is calculated by following(a) correspond to exercise 1, AHPs cash was about 23% of tally assets, rose constantly since 1978 to 1981, and reached 28.2% in 1981 thus, it has enough cash flow to finance its day by day operation.Also, return on assets can show that a firms ability to cover its operating cost by generating income. fit to the calculation below, American Home Products Corporations ROA was st able and most 19.2 % in 1981 consequently, AHP earned sufficient amount of income to cover its operating cost. class 2 Return on Assets of Amercan Home Products Corporation, 1972-1981 ($ in millions)Add to these above explanations, Exhibit 1 shows that AHPs peak annual harvest-tide in gross revenue was 14.1% in 1978 and compare to it, annual growth in sales decreased by 5.3% in 1981 as a result, it became dis gain to AHP because consumers started to spare- sentence activity into competitors products. Risk aversion was the most fundamental component of AHPs destination consequently, they prefer to acquire or take license of previously develop goods or produce similar products with its competitors earlier than to develop new-products. Although it seems to save R&D expenses, acquisition cost or a cost of time response to steal others innovation would be lock up appeared. Thus, AHP should try to improve its sales. b) Financial risk is related to business risk, so we measured NOPAT, ROIC, ROE whose uncertainty future can determine a firms business risk in Figure 3. Figure 3 Pro Forma 1981 Results for Alternative Capital Structures ($ in millions except ratios)supra pro forma illustrates that total debt and financial risk have straight correlativity with each other and AHPs total debt growingd, so its financial risk would rise. Then if American Home Products Corporation could not pay its bring and interest by memorandum, it would meet the financial risk and the ris k of bankruptcy. consort to Exhibit 4, AHP used excess cash of 233 million dollars on each of the proposed levels to repurchase stocks and remaining amounts were financed by debt thus, its mutual shares outstanding would decreased by 19.8 million shares on 30% dept ratio and 36.6 million shares on 70% debt ratio. It means that legality go away goes down, so its return on equity will rise. AHP should consider about financial risk to change the gravid expression.American Home Products Corporation can save taxes to pay by increasing debt. Figure 4 illustrates that its taxes savings can be advantage to AHP if it uses heavier pileus social system. Figure 4 Pro Forma 1981 Taxes Savings ($ in millions)According to Figure 4, if the companys capital structure is 70% debt to total capital, comparing to 30 % debt to total capital structure, it can save round 1.9 times greater money thus, its shareholders would benefit from it. 2. What capital structure would you barrack as appropriat e for AHP? What are the advantages of leveraging this company? The disadvantages? How would leveraging up affect the companys taxes? How would the capital markets answer to a decision by the company to enlarge the use of debt in its capital structure? Most appropriate capital structure for American Home Products is 30% debt to total capital. Several creators will explain the reason why this structure gives advantage to AHP. The first, as using 30% debt ratio, the company would be able to be recapitalized hence, common shares outstanding of 19.8 million can be repurchased. The second, jibe to Figure 4, AHP would have advantage to save taxes of 37.8 million dollars and its shareholders benefit by getting more values.Exhibit 2 shows that Warner Lambert companys debt ratio is approximately 32% and its bond rating is AAA or AA. It means that if AHP uses 30% debt and 70% equity, its bond rating will be same as Warner Lambert consequently, bond interest to pay will not increase much du e to bond rating. Addition to these reasons, AHP would face less risk to compare heavier capital structures. Finally, AHPs annual growth in sales decreased in 1981 by 2.9% from previous year, so getting debt could be helpful to worry its operation effectively and increase its sales growth. Besides above advantages, using 30% debt and 70% equity capital structure has disadvantages. First of all, if a firm has a loan, it has to be responsible to pay its principle and interest as a schedule otherwise, it would be reason to bankruptcy thus, same rule works on case of AHP. In addition to the risk of bankruptcy, if the companys daily operation requires more investment after recapitalization, getting new loan for it would be more difficult.In final, using debt can be reason to increase its financial risk, so it has to be more careful to manage its operation. According to Figure 4, leveraging the company by using 30% debt to capital structure would decrease its taxes of 37.8 million dollar s to pay. The capital market would react positively to a decision by the company to use of 30% debt in its capital structure. The company had almost no debt and had excess of cash or higher liquidity and Mr. Laborte who was chief executive of the company was closelipped to give his plant because of retirement, so most analysts expected the company to change its conservative capital structure. Also, Figure 5 shows the market positive chemical reaction on the stock expenditure. Figure 5 Stock Price of AHP ($ in millions except per share datas and ratios)According to Figure 5, AHPs stock expense will increase to 31.5. In order to calculate new stock price, we used average price/earnings ratio of both American Home Products Corporation and Warner Lambert Company in Exhibit 2 because exhibit 2 illustrates that while P/E ratio of AHP is 10.6%, 8% for Warner Lambert and unlike Warner Lambert, AHP has less financial risk. All though AHPs risk will increase after getting leverage and its P/E ratio will decrease, AHP would have better financial position than Warner Lambert, so investors would be interested to buy AHPs stock rather than stock of Warner Lambert.3. How magnate AHP implement a more aggressive capital structure policy? What are the alternative methods for leveraging up? AHP should use heavier capital structure which means that increase to use more debt preferably of conservative capital structure consequently, AHPs capital structure might be more effective and aggressive. The alternative methods for leveraging up are innovating new products, using better technology, and motivating labor. 4. In view of AHPs unique corporate culture, what arguments would you advance to persuade Mr. Laporte or his successor to ingest your recommendation?According to Mr. Laporte, his company works in order to increase shareholders wealth, so as using 30% debt to capital would give opening night to save 37.8 million dollars from taxes thus, its shareholders would benefit getting higher dividends per share. Even though after using debt, its price/earnings ratio might be decreased, its attraction of investors will be still powerful because of stock price increase. Also, if the company uses more debt to the operation, it will be possible to repurchase common stocks of 19.8 millions of shares from market.