Seminar assignments - American Home Products Case PDF

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American Home Products Corporation Case Course: FNCE 3P93 Due Date: February 14, 2016 Group Members 1.) Currently, American Home Products face fairly low risk. One reason is that firm has operated in the past without the need to obtain leverage. The firm shows confidence in its assets creating a lar...

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American Home Products Corporation Case Course: FNCE 3P93 Due Date: February 14, 2016 Group Members !

1.) Currently, American Home Products face fairly low risk. One reason is that firm has operated in the past without the need to obtain leverage. The firm shows confidence in its assets by creating a large cash reserve called financial slack. Overall the small amount of debt, low fixed cost commitments and a low default probability exemplify a fiscally strong organization. Another reason for the low risk of the organization is due to the nature of the majority of the product lines, which are primarily based on human necessities, and day-to-day items. The company has a low risk of defaulting due to debt, as shown in its large cash reserves. At each of the proposed levels the level of risk rises in correlation with increased debt. The company can produce additional value for its shareholders by saving taxes. Shareholders ROI increases from 33.4% to 38.3% when switching to a 30% debt leveraged capital structure. Past this point, it does not produce additional value for the shareholders, if the organization were to leverage with more than 30% debt. The Interest Times Earned of 415.13 is a very high number, which could signify that the company could benefit from debt financing. The Interest Times Earned is 17.5 at 30% debt and decreases in negative correlation with debt. ! Debt!

Actual!1981!(9%)! 13.9!

30%!Debt! 376.1!

50%!Debt! 626.8!

70%!Debt! 877.6!

Shares!Outstanding!

155.5!

135.7!

127.3!

118.9!

!

37.8!

54.7!

71.5!

$954.8!

$922.2!

$922.2!

$922.2!

415.13!

17.5!

10.5!

7.5!

$3.18!

$3.33!

$3.41!

$3.49!

Net!Operating!Profit!

497.3!

452.1!

433.9!

415.6!

Return!on!Investors!Capital!

33.4%!

38.3%!

38.3%!

38.3%!

Return!on!Equity!

33.8%!

51.5%!

69.2%!

110.5%!

1.012!

1.35!

1.81!

2.89!

1.9! 9.43! $30!

2.0! 9.01! $31.80!

2.04! 8.80! $32.60!

2.10! 8.60! $33.40!

.14!

0.19!

.23!

0.26!

Tax!Savings(Additional!debt!+!reduction!in! cash)! EBIT! Interest!Times!Earned!(Interest!coverage)! (EBIT/Interest)! EPS!

Financial! Leverage!Index! DPS(60%!of!EPS)! P/E!($30/EPS)! Stock!Price! WACC! !

2.) One of the main disadvantages of assuming to much debt is the increase of risk. As illustrated in exhibit 4 of the case, at 30% debt, AHP will be responsible for $362.2 million in debt. This number increases to $612.9 million and $863.7 million at the 50% and 70% debt levels respectively. This clearly illustrates a rise in AHP's bankruptcy risk the more debt it assumes. Alternatively, another disadvantage

of assuming more debt is a reduction in cash flow. AHP will need to use more cash flow to finance off the debt. This can shake shareholder confidence as debt to bondholders can take precedence over dividends. ! ! On the other hand, one benefit of increasing debt is the tax shield. Although interest expense to bondholders would increase, AHP's tax would decrease as interest expense would be tax deductible. As long as the tax shield is large enough it will be overcome the interest expense and benefit shareholders. With more debt, shareholders would benefit as dividends would increase. As shown in exhibit 3, the proforma statement illustrates dividends per share increase from $1.90 with no debt, $3.33 with 30% debt, $2.04 with 50% debt, and finally $2.10 with 70% debt. Thus we can see a direct and linear relationship between more and debt and shareholder value in terms of dividends per share.! 3.) Currently AHP uses a very conservative capital structure policy. In order to adopt a more aggressive capital structure policy AHP will have to issue more debt. The ideal way to issue debt is through bonds. As illustrated in exhibit 2, AHP's bond rating is AAA which means investors will feel safe buying AHP's bonds and providing the company with more capital. AHP can then use the proceeds to repurchase common stock. ! There are several alternative methods that AHP can use to leverage up. As mentioned in the case, AHP's corporate culture is very conservative and risk-averse. Instead of developing new products AHP would acquire and license new products from their competitors. With excess capital AHP could be able to research and develop it's own products. ! This will have several implications. The first is that it will reduce previous costs incurred through product licensing and acquisition. Additionally, AHP can now reap licensing and acquisition costs from it's competitors as AHP is now the one innovating and creating new products. Both of these factors will increase AHP's cash flow beyond what it would normally have without issuing debt. Alternatively, AHP could also use the excess capital to purchase new equipment and/or acquire new firms. Through this AHP will be able to streamline the production process and improve production efficiency. This has the dual effect of reducing production costs while generating more cash flow which boosts the firms bottom line and also improves shareholder value. It is important to note that AHP should gradually implement debt into their capital structure and not all at once. This is especially important since Laporte will be retiring for a new CEO and radical debt leveraging will shake shareholder confidence. 4.) Our recommendation for Mr. Laporte and his successor is to adopt the 30% debt leverage. Doing this has many benefits for AHP, especially in regard to its unique corporate culture. The case study tells us that their current corporate culture is of frugality. With this in mind we respect Mr. Laporte may not want to increase his debt at all. The case study also tells us that the business is run for the shareholders. Increasing the debt to 30% would be very beneficial to the shareholders of the company, as the value of shares will undoubtedly increase. This is likely to please the shareholders and increase their confidence in the company, which may lead them to having more loyalty for the company.

On a side note if Mr. Laporte’s successor were to come in and change the corporate structure of the company drastically this may have an adverse affect on the shareholders behaviour. They may see it as the company beginning a downward spiral and may dump their shares causing prices to fall. The successor should take some time to adjust to the company and how it works before making such a huge change. AHP has a large cash reserve which helps to make it very risk averse. The excess capital that can be raised from the bond leveraging would help to make the company even more risk averse. This extra capital can be used by Mr. Laporte to further expand the company’s marketing operations. This is his area of expertise and this could be very advantageous to the company in terms of increasing sales figures. At the same time this could help close the ‘head-start’ gap between AHP and its competitors. Investing excess capital in new machinery may also reduce the competitors ‘head-starts’. This could help make the production process quicker and more efficient and also possibly bring down the cost of their products. The company could also go down a different route. Currently AHP does not put money into ‘risky gambles’ such as R&D and new-product introductions. They could continue to operate as they are now but invest money into R&D. This could allow AHP flip the tables and possibly allow them to get ahead of their competitors rather than always playing ‘catch up’. This could also help shareholders confidence and increase share values. Increasing the debt to 30% looks like it would have many advantages. The excess capital could help reinforce the company’s marketing operations, be put into making the production process more streamlined or used to even further diversify the company more so than it already is. This would surely help to make AHP a stronger competitor within its many fields and improve the company’s future prospects. Mr. Laporte or his successor would be definitely benefit form this, as would shareholders. !...