How Much Business Risk Does American Home Products Face Essay

1. How frequently championship find does Ameri crapper class Products cheek? How much pecuniary risk would American Home Products face at each of the proposed takes of debt shown in case Exhibit 3? How much potential range, if any can American Home Products create for its postholders at each of the proposed levels of debt? (See Exhibits 1 and 2 )American Home Products currently has rugged business risk due to the conservative nature of their business. They piggyback on first moers to lower their research and development costs. They excel in trade therefore they concentrate on outselling their competitors. Also, they suffer low business risk because they ar diversified among four harvest lines prescription drugs, over the reverbe dimensionn drugs, food products, and housewares producing over 1500 products.Three of American Home Products product lines (prescription drugs, over the counter drugs, and food products) are within the defensive industries which mean they main tain little sensitivity to the business cycle. These industries outperform other(a)s even when the economy is bad. In addition, through diversification of manufacturing a variance of product lines, if one product line were to experience a decrease in sales, the other lines should theoretically pick up the slack. AMH appears to be a healthy union when looking for at its financial statements. AMHs net worth (total pluss-total debt) is 1,472.8 million. They have an additional immediate have a bun in the ovenment of $233 million.Their ROE, profit margin, ROA, and A/R receivable turnover old age all illustrate AMHs financial strength indicating that they can promptly generate cash to sustain their current growth rate, at 30.3%, 11.7%, 18.72%, AND 49.73 age respectively. AMH outperforms their persistence in all above mentioned ratios. (See Exhibit 1). yet it should be noted that their sales have decreased 5.3% from 14.1% in 1978 to 8.8% in 1981. This foreshadows executable ris k in the future tense. This is why AMH is rethinking their conservative and tightfisted sp quiting business approaches.Currently AMHs financial performance is strong. (Refer to Exhibit 2). Their high upshot on equity (ROE) at 30.3% illustrates how much profit the friendship is generating with the shareholders investments. In addition, they have low debt to equity and low debt to addition (debt) ratios both at .005. This further signals their financial strength. From the debt ratios we see that a flip-flop decrease in sales or an draw in matter to payments would not affect AMH because they have plenty of free cash flow. However the debt ratios withal indicate that management may not be responsibly growing the play along through the use of supplement and forgoing many an(prenominal) opportuni conjoins for future growth.Therefore when you compare the sum up of debt alternatives AMH has you can see an increase in debt to equity and debt to debt to asset ratios. For example t he debt to equity ratio increases at each level, 30%, 50%, and 70%, to .17,.32, and .513 respectively. The same is true for the debt to asset ratio. It increases to .15,.24,and .34 at 30%,50%,and 70% respectively. Although these could signal financial solvency issues, the industrys debt to equity ratio is .32, and their debt to asset ratio is .24. This is consistent with the AMHs 50% debt alternative option. However, the increase of debt adds value to the company.This is best illustrated when looking at the fee per share (EPS) and dividend payout ratio. As the debt increases so do both of the above mentioned ratios. EPS systematically increases from 3.18 with no added supplement to 3.33 at 30%, 3.41 at 50%, and 3.49 at 70%. The DPS ratio increase from .597 at no additional supplement to .602 at 70%. Shareholders often interpret an increase in dividends as an increase in confidence of future growth within the company.AMH is financially strong however, the provided statistics show it would be best for the company to increase its leverage to a certain level to add more than value to the well-wornholders. If it neverthe little utilizes the excess cash flow of $233 million to salvation stocks it only adds value to the stockholders in the short run. In the long run AMH should increase their leverage investing in areas such as R&D of clean and existing products. This go away not only increase value for the company but essentially add value to the stockholders. This reduces AMHs probable future risk of losing market share to competitors. I believe the certain level is the 30% alternative.2. What neat social organisation 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?I would recommend the 30% capital structure level. One rea son I chose this level is because of the already conservative business atmosphere. This level volition receive less apology for acceptance than the higher levels of 50% and 70%. It still keeps them above the industry on all performance ratios. (Recall that the industry is more consistent with the 50% alternative option.) This pass on increase their DPS from $1.90 to $2.00. This will increase confidence among investors. Their EPS will increase from 3.18 to 3.33 signally they are increasing value for the stockholders. AMHs dividend payout ratio will increase from .597 to .601.Their stock set should also increase from $30.00 to $35.66. This is forecasted by dividing the total market value of common stock ($4,838.56) by the come common shares outstanding (135.7 million). In addition there are other advantages of increase the firms leverage. They include creating a tax shield, generating more free cash flow for future expansions, generating more free cash flow to repurchase stock, a short run increase in EPS due to repurchase of stocks, and overall an increase to the intrinsic value of the company. As always with advantages, disadvantages are present to. They include an increase in financial risk.Despite the tax shield, the interest payment will result in a decrease to net income, and the hold fast rating could decrease to a AA status. The bond rating for a AAA is determined by a 18 Times Interest Earned Ratio. Once AMH increases their leverage to 30%, they will decrease their TIE to 17.50. Whereas, a AA is currently rated around a 9, further debt acquisition could result in a decrease of their bond rating and a decrease in value for stockholders. (Calculation EBIT/Interest= tie ratio 922.2/52.,7=17.50)Although the increased leverage decreases the amount of earnings available to stock holders from 496.9 million to 451.7 million for a total of 45.2 million dollars, it has a authoritative affect for the companys tax structure. It actually reduces the companys tax liability by 83 million dollars Without the debt they have to pay 952.5 million dollars in taxes. However after an increase of 30% leverage, the youngborn tax liability is 869.5 million dollars. Although the accounting value of the stock price appears more significant, the market value of the stock price will increase, too. Since you have to factor in the overbold-fangled liability of $362.2 million dollars for the debt, he new stockholders equity will be calculated at $4838.86 less 233 less 362.2 in millions arriving at $4,243.66 reducing the number of stock repurchases by 19.126.. indeed dividing the new stockholders equity by shares outstanding (136.374) and arriving at the new stock price of $31.12.3. How might AHP implement a more aggressive capital structure policy? What are the alternative methods for leveraging up?The unambiguous alternative for AMH to implement a more aggressive capital structure policy is to acquire more debt by utilizing the other options at 50% or 70%. Alternative methods for leveraging up include purchase shares of outstanding stock at the same time as the company issues bonds, create convertible security options for their stockholders where they can turn in stocks for the new bond securities, buy fixed assets, and utilizing derivatives in hedge funds to leverage the companys assets.4. In view of AHPs unique embodied culture, what arguments would you advance to persuade Mr. Laporte or his successor to adopt your recommendation? The very first thing I will do is show Mr. Laporte my charts that illustrate how increasing debt will bring an increase of overall stockholders wealth. My Laport believes that a companys main goal is to build value for stockholders, so I will start there. Since, I know he will be still be reluctant, I next will show him how the debt can be repurchased by AHP at a later date if he feels necessary. I will show him that the earnings available at the end of the year for common stockholders are more than the total debt amount.I will further show him that the net worth of the company is $1,654.5 which also could dump the costs. (The second option would actually be the better of the two options for repurchase of debt.) Then, I will show Mr. Laporte how the tax advantage will extradite the company 83 million dollars in the first year I will reassure him that the financial ratios already illustrate that he has splendid management skills and can efficiently and effectively manage the companys assets, thus he will excel with the new capital structure. Furthermore, the new leverage will still keep the company outperforming competitors within the industry. I will show him the industry ratio chart below. Lastly, I will suggest the increased free cash flow can also be utilized in research and development and perhaps gain a new absolute advantage