American Home Product

American Home Products

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

  The business risk of AHP is very low because it has very stable financial performance and consistent growth as well as profitability. Besides, it’s almost debt-free while the cash reserves are growing. And it’s risk-aversion and has a very tight financial control.

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

  With the increase of debt, the financial risk of AHP increases accordingly. As we can see that with 30% debt, earnings available to common shareholders decreased by 45.2million. And with 50% debt, earnings available to common shareholders decreased by 63.4million.

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

  Since we can pay less tax because of debt, EPS will increase. We can see it in Exhibit3 that earnings per share increased from $3.18 to $3.49 with the debt increased to 70%.

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

  I would recommend APH to have 30% debt.

  First of all, it’s no doubt that debt can save taxes and thus increase the EPS and ROE, which means debt has benefit to shareholders. Since one of the most common business platitudes is that a corporation’s primary mission is to make money for its stockholders and maximize profits by minimizing costs, the use of debt exactly meets this guideline.

  Second, the important components of AHP’s culture were conservatism and risk-aversion, so I think begin with 30% debt is easier to accept by this company.

  Besides, AHP’s competitor, Warner-Lambert had a debt ratio of 32% and its bond rating was on the borderline between AAA and AA. So I think the use of 30% debt is more appropriate.

  What’s more, 70% debt is much more risky than 30% debt. I think 30% debt is more appropriate for a risk-aversion company like AHP.

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

  The advantages are obvious. By using debt, we can save taxes and EPS and ROE will increase.