American Home Products Corporation Essay

840 words - 3 pages

Managing Corporate Capital Investment and Capital StructureCase 5American Home Products CorporationAssess American Home Products' (AHP) business risk.The business risk of a company includes βR which is related to its revenue and operating leverage which arises from fixed costs of production. In general, the pharmaceutical industry has a very high business risk due to high risks and costs that are associated with the research and development of new products. American Home Products has a low business risk in comparison to the industry. This is because of the unique nature of mimicking competitor's products and marketing them in a superior manner, AHP avoids large R&D expenditures. Because the R&D represents a large amount of fixed costs to the industry, all other factors being equal, the risk will be lower. Secondly the frugality of the company aids in avoiding unnecessary fixed costs, likewise aiding in the decreased business risk. Thirdly the company has over 1500 products which each have a different revenue streams, this diversification also decreases the variability of revenue to the corporation.2. Assess AHP's financial risk at each of the proposed levels of debt shown in case Exhibit 3. What bond rating would you expect at each level?Because a comparable company, Warner Lambert, has 32.4% debt and 5X interest coverage ratio we can use this as a benchmark to evaluate the bond rating for AHP. Since the debt of AHP was 30%, and AHP also had a times interest earned ratio of 415, we can conclude that the bond rating will be higher.
Table 1.1

Actual

30%

50%

70%

Debt Level ($)

13.9

376.1

626.8

877.6

Debt/cap

0.94

30

50

70

TIE

415

17.5

10.5

7.5

Expected bond rating

AAA

AAA

AA

A

3. How much value can AHP create for its shareholders at each of the proposed levels of debt under M&M 63? How would your answer change if personal taxes were incorporated in the analysis? Explain.
Table 1.2

Current

30% Debt

50% Debt

70% Debt

Value

4665

4838.856

4959.192

5079.576

Value= Value from operation + (tax + Change in debt)Value=4665 + ((376.1 - 13.9) *.48) = 4838.856Value=4838.856 + ((626.8 - 376.1) * .48)=4959.192Value=4959.192 + ((877.6 - 626.8) * .48)=5079.576As AHP adds debt under M&M 63 the value of the firm also increases. This is due to the interest tax shield of the debt.Because of the difference in tax rates for interest payments (ordinary income) and dividends (15% - 25%) as debt is added to the structure the payments are made to investors in the form of interest payments. Interest payments are taxed at ordinary income which should be higher than 25%. The value of the firm will decrease under this scenario.4. What capital structure...

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