1 American Home Products Corporation 1. 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? A combination of business risk and financial risk shows the risk of an organizations future return on equity. Business risk is related to make a firms operation without any debt, whereas financial risk requires that the firms 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 AHPs 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 729.1 2,588.5 28.2% 1980 593.3 2,370.3 25.0% 1979 493.8 2,090.7 23.6% 1978 436.6 1,862.2 23.4% 1977 322.9 1,611.3 20.0% 1976 358.8 1,510.9 23.7%

Cash Total Assets Proportion

2 According to Figure 1, AHPs 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 firms ability to cover its operating cost by generating income. According to the calculation below, American Home Products Corporations 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 Amercan Home Products Corporation, 1972-1981 ($ in millions)
1981 Net Income Total Assets ROA 497.3 2,588.5 19.2% 1980 445.9 2,370.3 18.8% 1979 396.0 2,090.7 18.9% 1978 348.4 1,862.2 18.7% 1977 306.2 1,611.3 19.0% 1976 277.9 1,510.9 18.4% 1975 250.7 1,390.7 18.0% 1974 255.6 1,241.6 20.6% 1973 199.2 1,126.0 17.7% 1972 172.7 1,042.0 16.6%

Add to these above explanations, Exhibit 1 shows that AHPs 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 AHPs 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 others 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 firms business risk in Figure 3. Figure 3 Pro Forma 1981 Results for Alternative Capital Structures ($ in millions except ratios)

3 Pro Forma 1981 for 30% Debt to 50% Debt to Total Capital Total Capital 376.1 626.8 877.6 626.9 1,253.7 14.0% 48.0% 922.2 452.1 479.5 38.3% 51.5% 1,253.7 14.0% 48.0% 922.2 433.9 479.5 38.3% 69.2%

Total Debt Net Worth Required Capital Interest Rate Tax Rate EBIT Profit After Tax NOPAT ROIC ROE

Actual 1981 13.9 1,472.8 1,486.7 14.0% 48.0% 954.8 497.3 496.5 33.4% 33.8%

70% Debt to Total Capital 877.6 376.1 1,253.7 14.0% 48.0% 922.2 415.6 479.5 38.3% 110.5%

Above pro forma illustrates that total debt and financial risk have straight correlation with each other and AHPs 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 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 50% Debt to Total Capital

Actual 1981

30% Debt to Total Capital

70% Debt to Total Capital

4 Taxes Taxes Savings 455.2 417.4 37.8 400.5 54.7 383.7 71.5

According to Figure 4, if the companys 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. 2. 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 companys taxes? How would the capital markets react to a decision by the company to increase the use of debt in its 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, according to Figure 4, 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 companys 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. Finally, AHPs annual growth in sales decreased in 1981 by 2.9% from previous year, so getting debt could be helpful to manage its operation effectively and increase its sales growth. Besides above advantages, using 30% debt and 70% equity capital structure has disadvantages. First of all, if a firm has a loan, it has to be responsible to pay its principle and interest as a schedule; otherwise, it would be reason to bankruptcy; thus, same rule works on case

5 of AHP. In addition to the risk of bankruptcy, if the companys daily operation requires more investment after recapitalization, getting new loan for it would be more difficult. In final, using debt can be reason to increase its financial risk, so it has to be more careful to manage its operation. According to Figure 4, leveraging the company by using 30% debt to capital structure would decrease its taxes of 37.8 million dollars to pay. 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. Also, Figure 5 shows the market positive reaction on the stock price. Figure 5 Stock Price of AHP ($ in millions except per share datas and ratios) Pro Forma 1981 for Actual 1981 497.3 155.5 3.2 1.9 10.6% 30.0 30% Debt to Total Capital 452.1 135.7 3.3 2.0 9.5% 31.5

Profit After Tax Averge Common Shares Outstanding (millions) Earnings Per Share Dividend Per Share Price/Earnings ratio Common Stock Price

According to Figure 5, AHPs stock price will increase to 31.5. In order to calculate new stock price, we used average price/earnings ratio of both American Home Products Corporation and Warner Lambert Company in Exhibit 2 because exhibit 2 illustrates that while P/E ratio of AHP is 10.6%, 8% for Warner Lambert and unlike Warner Lambert, AHP has less financial risk. All though AHPs risk will increase after getting leverage and its P/E ratio will decrease, AHP would

6 have better financial position than Warner Lambert, so investors would be interested to buy AHPs stock rather than stock of Warner Lambert. 3. How might AHP implement a more aggressive capital structure policy? What are the alternative methods for leveraging up? AHP should use heavier capital structure which means that increase to use more debt instead of conservative capital structure; consequently, AHPs capital structure might be more effective and aggressive. The alternative methods for leveraging up are innovating new products, using better technology, and motivating labor. 4. In view of AHPs unique corporate culture, what arguments would you advance to persuade Mr. Laporte or his successor to adopt your recommendation? 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.