American Home Products Corporation Case Analysis – Assignment Questions (Group 7)

2014

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REPORT

1. Is American Home Products Corporation a growth company?

Ans. Yes, American Home Products Corporation is definitely a growth company because it has shown a stable and consistent growth over the last 10 years ranging between 10% and 15% annually (referring to Exhibit 1).

2. How much business risk does American Home Products face? How much financial risk would American Home Products face at each of the proposed levels of debt shown in case Exhibit 3? How much potential value, if any can American Home Products create for its shareholders at each of the proposed levels of debt?

Ans. A combination of business risk and financial risk shows the risk of an organization’s future return on equity. Business risk is related to make a firm’s operation without any debt, whereas financial risk requires that the firm’s common stockholders make a decision to finance it with debt.

a) American Home Products has been operating on four main lines of business that are less uncertainty about product demand; for example, one of its business lines is food products because whenever people buy foods. It means that AHP’s business risk is low. As mentioned above, if a firm does its operation activities regularly without leverage, it means that its business risk 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 1976Cash 729.1 593.3 493.8 436.6 322.9 358.8Total Assets

2,588.5 2,370.3 2,090.7 1,862.2 1,611.3 1,510.9

Proportion

28.2% 25.0% 23.6% 23.4% 20.0% 23.7%

According to Figure 1, AHP’s cash was about 23% of total assets, rose constantly since 1978 to 1981, and reached 28.2% in 1981; thus, it has enough cash flow to finance its daily operation. Also, return on assets can show that a firm’s ability to cover its operating cost by generating income. According to the calculation below, American Home Products Corporation’s ROA was stable and approximately 19.2 % in 1981; consequently, AHP earned sufficient amount of income to cover its operating cost.

Figure 2 Return on Assets of American Home Products Corporation, 1972-1981 ($ in millions)

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　 1981 1980 1979 1978 1977 1976 1975 1974 1973 1972Net Income

497.3

445.9

396.0

348.4

306.2

277.9

250.7

255.6

199.2

172.7

Total Assets

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

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 sales was 14.1% in 1978 and compare to it, annual growth in sales decreased by 5.3% in 1981; as a result, 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 products with its competitors rather than to develop new-products. Although it seems to save R&D expenses, acquisition cost or a cost of time response to steal other’s innovation would be still appeared. Thus, AHP should try to improve its sales.

b) Financial risk is related to business risk, so we measured NOPAT, ROIC, ROE whose uncertainty 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)

　 　 Pro Forma 1981 for

　 Actual 1981

30% Debt to Total Capital

50% Debt to Total Capital

70% Debt to Total Capital

Total Debt 13.9 376.1 626.8 877.6Net Worth 1,472.8 877.6 626.9 376.1Required Capital

1,486.7 1,253.7 1,253.7 1,253.7

Interest Rate 14.0% 14.0% 14.0% 14.0%Tax Rate 48.0% 48.0% 48.0% 48.0%EBIT 954.8 922.2 922.2 922.2Profit After Tax

497.3 452.1 433.9 415.6

NOPAT 496.5 479.5 479.5 479.5ROIC 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 with each other and AHP’s total debt increased, so its financial risk would rise. Then if American Home Products Corporation could not pay its loan and interest by schedule, it would meet the financial

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risk and the risk of bankruptcy. According to Exhibit 4, AHP used excess cash of 233 million dollars on each of the proposed levels to repurchase stocks and remaining amounts were financed by debt; thus, its common shares outstanding would decreased by 19.8 million shares on 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 capital structure.

American Home Products Corporation can save taxes to pay by increasing debt. Figure 4 illustrates 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 1981

30% Debt to Total Capital

50% Debt to Total Capital

70% Debt to Total Capital

Taxes 455.2 417.4 400.5 383.7Taxes Savings

- 37.8 54.7 71.5

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 greater money; thus, its shareholders would benefit from it.

3. What capital structure would you recommend as appropriate for AHP? What are the advantages of leveraging this company? The disadvantages? How would leverage up affect the company’s taxes? How would the capital markets react to a decision by the company to increase the use of debt in its capital structure?

Ans. An appropriate capital structure for American Home Products is 30% debt to total capital.this can be supported as follows:

Using 30% debt ratio, the company would be able to be recapitalized; hence, common shares outstanding of 19.8 million can be repurchased. Control over the firm will be reduced by fewer hands

According to Figure 4 (pro forma of taxes savings), AHP would have a tax advantage of 37.8 million dollars for year 1981 and this will benefit its shareholders.

Also, bond rating for AHP will still remain as AAA even after using 30% debt. However, as it moves towards 50% debt, its bonds rating will fall. Hence, 30% debt is considered as appropriate.

Also, AHP would face less risk to compare heavier capital structures.

On the other hand, using 30% debt and 70% equity in capital structure has several disadvantages, described below:

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Raisng funds through debt will creat financial risk for firm and hence creates an obligation to pay interest (on regular basis) and principle amount. Moreover, debt creates risk of bankcruptcy.

In addition to the risk of bankruptcy, if the company’s daily operation requires more investment after recapitalization, firm, despite of its good brand image, may face difficulty in raising funds again through debt

As using debt leads to increase in its financial risk, so it has to be more careful to manage its operation.

The capital market would react positively to a decision by the company to use of 30% debt in its capital structure. The company had almost no debt and had excess of cash or higher liquidity and Mr. Laborte who was chief executive of the company was near to give his position because of retirement, so most analysts expected the company to change its conservative capital structure.

4. How might AHP implement a more aggressive capital structure policy? What are the alternative methods for leveraging up?

Ans. AHP can implement an aggressive capital structure policy by increasing debt in its capital structure. The alternative methods for leveraging up can be innovation and using better technology as it was known for being a “me too” company. It was never a first mover of the market.

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?

Ans. According to Mr. Laporte, his company works in order to increase shareholders wealth, so as 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 powerful because of stock price increase. Also, if the company uses more debt to the operation, it will be possible to repurchase common stocks of 19.8 millions of shares from market.

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