American Home Products Case Study

American Home Products Corporation

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) Business risk

AHP has low business risk because they have diversified their product lines into four different product lines, and because of their conservative way of doing business. When we calculated the ratio of cash to total assets we could have seen that firm does not increase leverage to finance its operation, in fact it has enough cash to finance its daily operations.

Proportion=cashtotal assets

　 | 1981 | 1980 | 1979 | 1978 | 1977 | 1976 |

Cash | 729.1 | 593.3 | 493.8 | 436.6 | 322.9 | 358.8 |

Total 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% |

Figure 1

As we can see in figure 2 AHP managed to cover its costs by generating income, AHPs ROA was approximately 19.2% in 1981, that means that AHP earned a sufficiend amount to cover its costs.

ROA=Net IncomeTotal Assets

| 1981 | 1980 | 1979 | 1978 | 1977 | 1976 | 1975 | 1974 | 1973 | 1972 |

Net 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% |

Figure 2 Return on Assets of the AHP

The only downside to their risk averse business is their annual growth in sales wich declined for 5.3% between the years 1978 and 1981, that shows that they face future risk.

b) Financial Risk

| 30% Debt to Total Capital | 50% Debt to Total Capital | 70% Debt to Total Capital |

Total Debt...