American home products corporation copy

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American Home Products Corporation
1. How much business risk does American Home Products face? How much financial risk
would American Home Products face at each of the proposed levels of debt shown in case
Exhibit 3? How much potential value, if any can American Home Products create for its
shareholders at each of the proposed levels of debt?
A combination of business risk and financial risk shows the risk of an organization’s future
return on equity. Business risk is related to make a firm’s operation without any debt, whereas
financial risk requires that the firm’s common stockholders make a decision to finance it with
debt.
a) American Home Products has been operating on four main lines of business that are less
uncertainty about product demand; for example, one of its business lines is food products
because whenever people buy foods. It means that AHP’s business risk is low. As mentioned
above, if a firm does its operation activities regularly without leverage, it means that its business
risk is not significant high. Thus, ratio of cash to total assets is calculated by following:



Figure 1 Proportion of cash and total assets, 1976-1981 ($ in millions)

1981 1980 1979 1978 1977 1976
Cash 729.1 593.3 493.8 436.6 322.9 358.8
Total
Assets
2,588.5 2,370.3 2,090.7 1,862.2 1,611.3 1,510.9
Proportion 28.2% 25.0% 23.6% 23.4% 20.0% 23.7%

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According to Figure 1, AHP’s cash was about 23% of total assets, rose constantly since
1978 to 1981, and reached 28.2% in 1981; thus, it has enough cash flow to finance its daily
operation.
Also, return on assets can show that a firm’s ability to cover its operating cost by
generating income. According to the calculation below, American Home Products Corporation’s
ROA was stable and approximately 19.2 % in 1981; consequently, AHP earned sufficient
amount of income to cover its operating cost.
Figure 2 Return on Assets of Amercan Home Products Corporation, 1972-1981 ($ in millions)

1981 1980 1979 1978 1977 1976 1975 1974 1973 1972
Net
Income
497.3 445.9 396.0 348.4 306.2 277.9 250.7 255.6 199.2 172.7
Total
Assets
2,588.5 2,370.3 2,090.7 1,862.2 1,611.3 1,510.9 1,390.7 1,241.6 1,126.0 1,042.0
ROA 19.2% 18.8% 18.9% 18.7% 19.0% 18.4% 18.0% 20.6% 17.7% 16.6%

Add to these above explanations, Exhibit 1 shows that AHP’s peak annual growth in sales
was 14.1% in 1978 and compare to it, annual growth in sales decreased by 5.3% in 1981; as a
result, it became disadvantage to AHP because consumers started to interest into competitors’
products. Risk aversion was the most fundamental component of AHP’s culture; consequently,
they prefer to acquire or take license of previously developed goods or produce similar products
with its competitors rather than to develop new-products. Although it seems to save R&D
expenses, acquisition cost or a cost of time response to steal other’s innovation would be still
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 firm’s business risk in Figure 3.
Figure 3 Pro Forma 1981 Results for Alternative Capital Structures ($ in millions
except ratios)

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Pro Forma 1981 for

Actual
1981
30% Debt to
Total Capital
50% Debt to
Total Capital
70% Debt to
Total Capital
Total Debt 13.9 376.1 626.8 877.6
Net Worth 1,472.8 877.6 626.9 376.1
Required
Capital
1,486.7 1,253.7 1,253.7 1,253.7
Interest Rate 14.0% 14.0% 14.0% 14.0%
Tax Rate 48.0% 48.0% 48.0% 48.0%
EBIT 954.8 922.2 922.2 922.2
Profit After
Tax
497.3 452.1 433.9 415.6
NOPAT 496.5 479.5 479.5 479.5
ROIC 33.4% 38.3% 38.3% 38.3%
ROE 33.8% 51.5% 69.2% 110.5%

Above pro forma illustrates that total debt and financial risk have straight correlation with
each other and AHP’s total debt increased, so its financial risk would rise. Then if American
Home Products Corporation could not pay its loan and interest by schedule, it would meet the
financial risk and the risk of bankruptcy. According 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 common 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 equity will goes down,
so its return on equity will rise. AHP should consider about financial risk to change the capital
structure.
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 capital structure.
Figure 4 Pro Forma 1981 Taxes Savings ($ in millions)
Pro Forma 1981 for

Actual
1981
30% Debt to
Total Capital
50% Debt to
Total Capital
70% Debt to
Total Capital

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Taxes 455.2 417.4 400.5 383.7
Taxes
Savings
- 37.8 54.7 71.5

According to Figure 4, if the company’s capital structure is 70% debt to total capital,
comparing to 30 % debt to total capital structure, it can save approximately 1.9 times greater
money; thus, its shareholders would benefit from it.
2. What capital structure would you recommend as appropriate for AHP? What are the
advantages of leveraging this company? The disadvantages? How would leveraging up affect the
company’s taxes? How would the capital markets react to a decision by the company to increase
the use of debt in its capital structure?
Most appropriate capital structure for American Home Products is 30% debt to total capital.
Several reasons 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, according 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 company’s 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 due
to bond rating. Addition to these reasons, AHP would face less risk to compare heavier capital
structures. Finally, AHP’s annual growth in sales decreased in 1981 by 2.9% from previous year,
so getting debt could be helpful to manage 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

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of AHP. In addition to the risk of bankruptcy, if the company’s 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 dollars 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 near to give his position
because of retirement, so most analysts expected the company to change its conservative capital
structure. Also, Figure 5 shows the market positive reaction on the stock price.
Figure 5 Stock Price of AHP ($ in millions except per share datas and ratios)
Pro Forma 1981 for

Actual
1981
30% Debt to Total Capital
Profit After Tax 497.3 452.1
Averge Common Shares Outstanding
(millions)
155.5 135.7
Earnings Per Share 3.2 3.3
Dividend Per Share 1.9 2.0
Price/Earnings ratio 10.6% 9.5%
Common Stock Price 30.0 31.5

According to Figure 5, AHP’s stock price 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 AHP’s risk will increase after getting leverage and its P/E ratio will decrease, AHP would

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have better financial position than Warner Lambert, so investors would be interested to buy
AHP’s stock rather than stock of Warner Lambert.
3. How might 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 instead
of conservative capital structure; consequently, AHP’s 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 AHP’s unique corporate culture, what arguments would you advance to
persuade Mr. Laporte or his successor to adopt your recommendation?
According to Mr. Laporte, his company works in order to increase shareholders wealth, so
as using 30% debt to capital would give possibility 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.