1 American Home Products Corporation 1. How much business risk does American Home Products face? How much financial riskwould American Home Products face at each of the proposed levels of debt shown in caseExhibit 3? How much potential value, if any can American Home Products create for itsshareholders at each of the proposed levels of debt? A combination of business risk and financial risk shows the risk of an organization’s futurereturn on equity. Business risk is related to make a firm’s operation without any debt, whereasfinancial risk requires that the firm’s common stockholders make a decision to finance it withdebt. a) American Home Products has been operating on four main lines of business that are lessuncertainty about product demand; for example, one of its business lines is food productsbecause whenever people buy foods. It means that AHP’s business risk is low. As mentionedabove, if a firm does its operation activities regularly without leverage, it means that its businessrisk 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 2,588.5 2,370.3 2,090.7 1,862.2 1,611.3 1,510.9 Assets Proportion 28.2% 25.0% 23.6% 23.4% 20.0% 23.7%
2 According to Figure 1, AHP’s cash was about 23% of total assets, rose constantly since1978 to 1981, and reached 28.2% in 1981; thus, it has enough cash flow to finance its dailyoperation. Also, return on assets can show that a firm’s ability to cover its operating cost bygenerating income. According to the calculation below, American Home Products Corporation’sROA was stable and approximately 19.2 % in 1981; consequently, AHP earned sufficientamount 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 497.3 445.9 396.0 348.4 306.2 277.9 250.7 255.6 199.2 172.7 Income Total 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 Assets 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 saleswas 14.1% in 1978 and compare to it, annual growth in sales decreased by 5.3% in 1981; as aresult, 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 productswith its competitors rather than to develop new-products. Although it seems to save R&Dexpenses, acquisition cost or a cost of time response to steal other’s innovation would be stillappeared. Thus, AHP should try to improve its sales. b) Financial risk is related to business risk, so we measured NOPAT, ROIC, ROE whoseuncertainty 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)
3 Pro Forma 1981 for Actual 30% Debt to 50% Debt to 70% Debt to 1981 Total Capital Total Capital Total Capital Total Debt 13.9 376.1 626.8 877.6 Net Worth 1,472.8 877.6 626.9 376.1 Required 1,486.7 1,253.7 1,253.7 1,253.7 Capital 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 497.3 452.1 433.9 415.6 Tax 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 witheach other and AHP’s total debt increased, so its financial risk would rise. Then if AmericanHome Products Corporation could not pay its loan and interest by schedule, it would meet thefinancial risk and the risk of bankruptcy. According to Exhibit 4, AHP used excess cash of 233million dollars on each of the proposed levels to repurchase stocks and remaining amounts werefinanced by debt; thus, its common shares outstanding would decreased by 19.8 million shareson 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 capitalstructure. American Home Products Corporation can save taxes to pay by increasing debt. Figure 4illustrates 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 30% Debt to 50% Debt to 70% Debt to 1981 Total Capital Total Capital Total Capital
4 Taxes 455.2 417.4 400.5 383.7 Taxes - 37.8 54.7 71.5 Savings 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 greatermoney; thus, its shareholders would benefit from it. 2. What capital structure would you recommend as appropriate for AHP? What are theadvantages of leveraging this company? The disadvantages? How would leveraging up affect thecompany’s taxes? How would the capital markets react to a decision by the company to increasethe 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, asusing 30% debt ratio, the company would be able to be recapitalized; hence, common sharesoutstanding of 19.8 million can be repurchased. The second, according to Figure 4, AHP wouldhave advantage to save taxes of 37.8 million dollars and its shareholders benefit by getting morevalues. Exhibit 2 shows that Warner Lambert company’s debt ratio is approximately 32% and itsbond rating is AAA or AA. It means that if AHP uses 30% debt and 70% equity, its bond ratingwill be same as Warner Lambert; consequently, bond interest to pay will not increase much dueto bond rating. Addition to these reasons, AHP would face less risk to compare heavier capitalstructures. 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 hasdisadvantages. First of all, if a firm has a loan, it has to be responsible to pay its principle andinterest as a schedule; otherwise, it would be reason to bankruptcy; thus, same rule works on case
5of AHP. In addition to the risk of bankruptcy, if the company’s daily operation requires moreinvestment after recapitalization, getting new loan for it would be more difficult. In final, usingdebt can be reason to increase its financial risk, so it has to be more careful to manage itsoperation. According to Figure 4, leveraging the company by using 30% debt to capital structurewould 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% debtin its capital structure. The company had almost no debt and had excess of cash or higherliquidity and Mr. Laborte who was chief executive of the company was near to give his positionbecause of retirement, so most analysts expected the company to change its conservative capitalstructure. 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 30% Debt to Total Capital 1981 Profit After Tax 497.3 452.1 Averge Common Shares Outstanding 155.5 135.7 (millions) 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 31.5According to Figure 5, AHP’s stock price will increase to 31.5. In order to calculate new stockprice, we used average price/earnings ratio of both American Home Products Corporation andWarner Lambert Company in Exhibit 2 because exhibit 2 illustrates that while P/E ratio of AHPis 10.6%, 8% for Warner Lambert and unlike Warner Lambert, AHP has less financial risk. Allthough AHP’s risk will increase after getting leverage and its P/E ratio will decrease, AHP would
6have better financial position than Warner Lambert, so investors would be interested to buyAHP’s stock rather than stock of Warner Lambert. 3. How might AHP implement a more aggressive capital structure policy? What are thealternative methods for leveraging up? AHP should use heavier capital structure which means that increase to use more debt insteadof conservative capital structure; consequently, AHP’s capital structure might be more effectiveand aggressive. The alternative methods for leveraging up are innovating new products, usingbetter technology, and motivating labor. 4. In view of AHP’s unique corporate culture, what arguments would you advance topersuade Mr. Laporte or his successor to adopt your recommendation? According to Mr. Laporte, his company works in order to increase shareholders wealth, soas 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 powerfulbecause of stock price increase. Also, if the company uses more debt to the operation, it will bepossible to repurchase common stocks of 19.8 millions of shares from market.