American Home Product 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?

American Home Product Corporation had negligible business risk in 1980. It had a high net worth $ 1472.8 million and had an excess cash of $ 233 million (exhibit 1). American Home Product Corporation had a Return on Assets of 18.11% and had a profit margin of 11%, which was pretty healthy (Exhibit A). It had a high return on equity of 30.0 % (exhibit 1). In 1980, the company had both the ability to generate enough income from its assets and was earning healthy net income in comparison to the revenue it was making. However, growth in sales had dropped, which was 10% in 1979 to 8% in 1981(exhibit 1). Sales drop could have been due to American Product Corporation’s very low expenditure in Research and Development or due to its competitors picking up pace in sales from American Corporation.

At the 30 % level of debt, the Corporation had degree of financial leverage of 1.062. At 50% level of debt, the Corporation had a financial leverage of 1.106, while at the 70 % level of debt; the Corporation faced a financial risk of 1.115. The above ratio shows that the company faced more financial risk at an increased level of debt (Exhibit B).

The potential value the firm creates for its shareholders is measured from its Earnings per share and Dividends per share. At 30% level, the firm created Earnings and Dividends per share of $ 3.33 and $ 2. At 50% level, it created Earnings and dividends per share of $ 3.41 and $2.04, while it created the greatest level of Earnings and Dividends per share at 70% level of debt of $ 3.49 and $ 2.10. So, the company created highest potential value at 70% level of debt.

What capital structure would you recommend as appropriate for...