American Home Product

1. How much business risk does American Home Product face? How much financial risk would American Home Product face at each of the proposed levels of debt shown in case Exhibit 3? (Hint: Calculate impact on net income of 10% reduction in EBIT). How much potential value, if any, can AHP create for its shareholders at each of the proposed levels of debt?

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2.Construct a simple EBIT-EPS Analysis chart for AHP for each of the proposed levels of debt shown in case Exhibit

3. Give your analysis based upon this chart. 3.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 taxes? How would the capital markets react to a decision by the company to increase the use of debt in its capital structure?

4.How might AHP implement a more aggressive capital structure policy? What are the alternative methods for leveraging up? (Short answer will be OK, no calculation).

5.In view of AHP’s unique corporate culture, what arguments would you advance to persuade Mr. Laporte or his successor to adopt your recommendation?

Note: Make sure that you do understand how to find the numbers on Exhibit 3 and Exhibit 4, number 8.
1.Business risk:
Stable annual growth (10~15%) and profit margin (11~12%).
Overall low-risk investments; ‘proven’ formulas instead of R&D. AAA Bond Rating.
(EBIT 1981 / EBIT 1980) / % increase in sales
(EBIT 1981 / (Net Income 1980 / (1 – Tax Rate))) / % increase in sales (EBIT 1981 / (Net Income 1980 / (1 – 48%))) / % increase in sales (954,8 / (445,9 / 52%)) / (4.131,2 / 3.798,5) = 1,02.
(954,8 / 857,5) / 108,8% = 1,02.

Financial risk:
DFL = % change EPS / % change EBIT
= (1 + ((3,18 – 2,84) / 2,84)) / (1 + ((954,8 – 857,5) / 857,5))
= 1,120 / 1,113
= 1,006.
Higher DFL means higher EPS variability.
0%  1,006
30% 1,090
50%  1,116
70%  1,143
Debt to Capital = total debt / net worth. Higher DtC ratio means higher risk. 0% 0,009
30% 0,429
50% 1,000
70% 2,333

Potential value:
EPS goes up as % of debt goes up ($3.18 – $3.49).
0% $3.18
30% $3.33
50% $3.41
70% $3.49

Dividends rise.
0% $1.90
30% $2.00
50% $2.04
70% $2.10

2.EBIT-EPS Analysis Chart

Although leveraging decrease the company’s EBIT, it gives more value per share to its shareholders.

3.Recommended 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, 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.

The advantages of leveraging this company:
a.Higher value for shareholders.
b.Reduction in tax through interest.
c.Access to additional capital.

The disadvantages of leveraging this company:
a.Higher risk to shareholders.
b.Lower net income.

Leveraging effect:
As debt increases, tax decreases.

Market reaction:
Market will expect higher return and stock price will rise.

4.AHP should use heavier capital structure which means increasing to use more debt instead of relying wholly on shareholders’ capital, which has its limitation as far as the shareholders’ wealth. So, by using debt to finance AHP’s growth (leveraging up), AHP’s capital structure might be more effective and aggressive. Leveraging up may enable AHP in innovating new products, using better technology, and motivating labor. While during Mr. Laporte’s era, the company can only conduct the “me too” strategy, relying heavily on its marketing prowess.

5.Mr. Laporte stated that his company works in order to increase shareholders’ wealth. However, using 30% debt to capital would give possibility to save 37.8 million dollars from taxes; thus, its shareholders would benefit from getting higher dividends per share. Also, if the company uses more debt to its operations, it will be possible to repurchase common stocks of 19.8 millions of shares from market, increasing its EPS, thus affecting in rise in stock price.

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