Merican Home Products Corporation Capital Structure

Case 1: American Home Products Corporation Capital Structure

Section 3

American Home Products Corporation Capital Structure

1.

American Home Products Corp. has almost no financial risk at the current capital structure. The company has low risk the 30% debt restructuring, low risk at 50% debt and low-medium risk at 70% debt. The table demonstrates that at each level of debt the firm can pay over the interest expense. At the highest level of debt the firm can pay the interest seven times.

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

D/E | 0.3% | 8.83% | 15.31% | 22.43% |

Share Price | $30.00 | $31.40 | $32.16 | $32.91 |

Interest Coverage | 415x | 17.5x | 10.5x | 7.5x |

Calculations for ratios found in Appendix

2. The best type of capital structure for any firm is the capital structure that maximizes the value of a share of stock; this then maximizes the value of the firm. The D/E ratio chosen should also minimize the WACC. The best capital structure for American Home Products is a 70% debt to total capital because it has the highest share price and firm value with little risk of being unable to repay the interest. Even though AHP has historically been unlevered and demonstrated “growth and profitability,” the calculations done in Question 1 show how debt/leveraging can be used to AHP’s advantage. Under 30%, 50%, and 70% debt structures, both EPS and dividends per share increase, seen in exhibit 3.

The advantages of leveraging this company include tax shields/savings, more cash freed up for other uses, and they can also take advantage of the best available interest and tax rates. Choosing the best leveraging strategy will allow American Home Products to maximize share value (EPS), and shareholder profits (ROE), while also maximizing firm value. Some disadvantages of leveraging this firm include: increased risk, too much debt can decrease the ROE, more debt pushes companies...