Amercian Home Products

Case Analysis: Introduction to Debt Policy & Value

1. How much business risk does American Home Products face? How much financial risk would American Home Proudest 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 proposed levels of debt?

β L = β U [1 + D/E (1-T)]

Where β L is the leveraged beta, β U is the unleveraged beta, D/E is the debt to equity ratio, and T is the tax rate.

The equation above can be used to separate the financial risk (β L) of a levered firm from its business risk (β U).

RE = Rf + β U (Rm - Rf)

Where RE is the required rate of return on equity, β U is the unleveraged beta, Rf is the risk-free interest rate, and Rm is the risk premium.

An increase in a company’s debt level also increases its business risk. One of the most important factors that cause an increase in business risk is the variability in sales. In addition, the operating leverage of a company also plays an important role on the company’s business risk. In general, pharmaceutical companies have high business risk due to the high cost in research and development of new products. American Home Products has a relatively low business risk due to the following:

1. American Home Product’s cultures were conservatism and risk-aversion. The company’s managerial philosophy was frugality and tight financial control, which helped the company to avoid unnecessary costs and reduced business risk.

2. The company consistently avoided much of the risk of new-product development and introduction in the volatile drug industry. Most of the company’s new products either were acquired or licensed after their development by other firms or they were copies of new products introduced by competitors. Furthermore, a substantial number of the company’s new products were clever extensions of existing products. Research and development expenditure is a big...