American Home Products

American Home Products Corporation

1. 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 show 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?

American Home Products faces a small amount of business risk. First, they actively avoid taking on new debt based on William F. Laporte’s conservative nature. Laporte simply says he “does not like to owe money.” The company is also involved in a lower risk market than most. Their largest area of operations, pharmaceuticals, typically is not hindered as much as other markets during economic changes. The company’s strong networth of 1,472.8 million dollars is very close to a similar company’s networth in the same industry. This networth; however, is achieved with a debt-to-equity ratio of 0.09 percent. This ratio is a sign that the company has low business risk. The company also boasts an impressive return-on-equity ratio of 30.1 percent, emphasizing that the company in successful in their operations. Recently, AHP’s annual growth has been below par. In 1981 it is near its ten year low of annual growth. This could pose a risk of a lack of interest towards AHP products. If AHP decides to increase its borrowing to any of the proposed levels, its financial risk will increase along with the new debt. The advantage of taking on new debt is tax saving. If AHP decides to employ the strategy of 30 percent debt to capital, their tax savings will be 37.8 million dollars. As more debt is added, so are tax savings. The 50 percent debt to capital level will result in 54.7 million dollars in tax savings. Finally, the 70 percent debt to capital level means 71.5 million dollars in tax savings. Along with increasing tax savings, an increase in debt will also change EPS and DPS ratios. Increases in these ratios could prove beneficial to...