American Home Products Case Solution

American home products (AHP) corporation’s business is distributed among prescribed drugs, food items, household products and packaged medication. The business risk of AHP can be deemed on the lower side of the spectrum considering the business lines of the firm. The firm’s operational activities are not leveraged and thus the amount of business risk involved was at a significantly lower level compared to its peers. The firm managed its business operations with its accumulated cash reserves with no considerable risk of default.

The case asked us to analyze into the prospect of changes to basic financial ratios and valuations by introducing different levels of debt and the results clearly suggest that even though the business risk positively correlates with the increase in the firm’s leverage, there is a very significant increase in the returns of the shareholders which according to the firm’s CEO has always been the priority. We see that when the debt ratio of the firm increases from less than 0.93% to 30%, the return on equity appreciates from 33.6% to 51.5%. As we go further with higher levels of debts like 50% and 70%, the return on equity comes out to be 69.2% and 110.5% respectively. So, the shareholders would eventually benefit with the capital restructuring depending upon the risk appetite of the firm’s management.    

Under the given assumption of no tax shield, the price per share after restructuring doesn’t change. Even though the market value of equity reduces with the increase in the debt, the number of shares outstanding also decrease in an equal proportion, thus the share price stays at $30 for all the different capital structures. This is also in agreement with M&M proposition of capital structure irrelevance to the stock price. Capital restructuring from no debt to higher debt ratios leads us to depreciating P/E ratios. The P/E ratio reduces from 9.4 to 9.0 when the leverage in the capital structure is increased from 0.93% to 30% which means a lower price to be paid per unit of earnings. Also, there is a positive correlation between the EPS and the leverage of the firm. So, the stakeholders get higher earnings per share with capital restructuring.  

The interest coverage at less than 1% leverage is significantly high (415.1) indicating possible benefits of corporate restructuring. At higher debt ratios of 30%, 50% and 70%, the value of interest coverage falls to 17.5, 10.5 and 7.5 respectively. The firm’s high earnings allows it to afford an increase in debt percentage and thus the business risk in order to maximize the returns.  

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We also analyze the case considering that there is a tax shield advantage that the corporation would benefit from when they would restructure and add debt and we measure those effects on the shareholders. With the added tax benefits, the market value of the equity increases, thereby, increasing the price per share. We assume that the information related to added tax benefits do not get reflected in the stock price before the purchase and the buyback happens at $30 per share at all levels of debt. The added tax benefits get distributed among the investors that prefer to stay with the firm. Also, there is a positive correlation between the level of debt undertaken and the new share price after the exchange.