American Home Product

1. How much business risk does American Home Products face?

AHP faces a low business risk because it marketed brands in four lines of business: prescription drugs, packaged drugs, food products, and housewares and household products. These four mainlines have less uncertainty about product demand. Even though there is a financial crisis, people also should buy these stuffs, therefore, these four lines won’t be largely affected by bad economy situation so that it has low business risk.

2. How much financial risk would American Home Products face at each of the proposed levels of debt as shown in case Exhibit 3?

From Exhibit3, AHP paid interest at $451.7m, $433.5m, $415.2m on debt to total capital ratio at 30%, 50%, 70%, respectively. Also, its total debt increases from $376.1m to $626.8m to $877.6m with the increasing percentage of debt and the company’s net worth decreased dramatically from $877.6m to $626.9m to $376.1m, which means with the debt proportion increases, the financial risk increases dramatically.

3. How much potential value, if any, can American Home Products create for its shareholders at each of the proposed levels of debt?

From Exhibit4, AHP excess cash is 233 million dollars on these three proposed levels to repurchase stocks and change these part to debt, which causes reduction in stock outstanding and the price of equity goes up. Besides, with the increasing proportion of debt to capital, the company also have more tax saving: $376.1m*0.48 = $180.53m, $626.8*0.48 = $300.86mm, $877.6m*0.48 = $421.25m, respectively, which means more earnings are switched to equity part to increase shareholders’ wealth.

From Exhibit3, earnings per share are $2.00m, $2.04m, $2.10m at 30%, 50%, 70% debt to capital, respectively

4. What capital structure would you recommend as appropriate for American Home Products?

For AHP, I would recommend 30% debt to total capital. From Exhibit2, Warner- Lambert company’s ratio of total debt to total capital is 32.4% and it has a high bond rate, AAA/AA*, which means that if AHP also has approximately 30% debt and 70% equity, it can also have a high bond rate. Besides, 30% debt of total capital means lower financial risk.

5. What are the advantages of leveraging this company? The disadvantages?

Advantage: Through using debt to raise part of financial capital, company can reduce its tax expense, for example, from Exhibit3, at 30%, 50%, 70% debt to total capital, company can have tax savings: $376.1m*0.48 = $180.53m, $626.8*0.48 = $300.86mm, $877.6m*0.48 = $421.25m, respectively.

Disadvantage: With the increasing proportion of debt, AHP’s financial risk is increased, it easier to bankruptcy and also because of the increased risk, they should pay more dividend and interest to their shareholders.