Write Up on American Home Products Corporation free essay sample

Write UP On AMERICAN HOME PRODUCTS CORPORATION: Company Overview Background Information: American Home Products Corporation (AHP), is a pharmaceutical company. The company was based in Madison, New Jersey, USA. They were known for manufacturing the over-the-counter (OTC) drugs Robitussin and the analgesic Advil (ibuprofen), as well as the prescription drugs Premarin and Effexor, which both boast over US$3 billion in sales annually. American Home Product Corporation (AHP), a highly growing American company, has four business lines: prescription drugs, packaged drugs, food products, house wares and household products. For a quite long time, AHP has applied a tight financial control and maintained an aggressive capital structure policy. Its mission is to make money for its stockholders and to maximize profits by minimizing costs. It has been able to finance internally its growth while paying a very high portion of its earning to its shareholders (60%) Currently, AHP seems to have no business risk but may face a certain risk in the long run. Based on the ratios shown on the attached sheet, AHP should not worry about business risk since its working capital is very healthy and have cash excess. The high ROA, high profit margin, low current-to-asset ratio and collection days show that AHP can generate cash quickly, thus it can maintain current high growth rate. However, it’s decreasing annual sales growth shows that it faces future risk of losing market shares in all its business lines if it does not foresee competition and continue to focus on increasing stockholders’ value. AHP’s current financial performance is very good since it has high ROE, high quick ratio, low debt-to-equity ratio and low debt-to-asset ratio. However, the pro forma of different debt ratios show that if AHP increases debt ratio, it will face a financial risk of increased debt-to-equity and debt-to-asset ratios. In other words, it will face solvency problems in long terms. AHP also face liquidity problems since the quick ratios decrease when the debt ratios increase. In contrast, shareholders’ value increases when debt ratios increase. EPS increases. The dividend payout ratio also increases similarly, the dividend yield as well. It seems that the company can increase shareholders’ value by increasing debt ratios. Even though AHP has a very good current financial performance, it should change the financial policy to increase debt ratio at a certain level to meet the goal of increasing shareholders’ val Major Focus Areas of the Case: ?Capital structure ?Debt management ?Financial strategy Financial analysis: ?At the end of 1980, AHP had almost no debt and a cash balance equal to 40% of its net worth ? â€Å"I just don’t like to owe money†, said William F. Laporte, AHP chief executive, when asked about his company’s almost debt-free balance sheet and growing cash reserves. Mr. Laporte had taken over as chief executive of American Home Products in 1964. Throughout 17 subsequent years of his tenure Mr. Laporte has not changed his opinion of debt financing and AHP’s abstinence from debt continued, while the growth in its cash balances outpaced impressive growth in both sales and earnings. ?At the end of 1980, AHP had almost no debt and a cash balance equal to 40% of its net worth. AHP’s Performance : ?Stable, consistent growth and profitability†¦ increased sales, earnings, and dividends for 29 consecutive years through 1981. In 1981, after 17 years as chief executive, Mr. Laporte was approaching retirement, and analysts speculated on the possibility of a more aggressive capital structure policy. Questions Answered A. How much business risk does America Home Products face? AHP has a low business risk B. How much financial risk would AHP face at each of the proposed levels of debt shown in exhibit 3? Financial risk is a function of the company’s business risk multiplied by the debt/equity (D/E) ratio. Thus the higher the D/E ratio,the greater the leverage and financial risk. The following table provides the D/E ratios at each proposed level, which indicates the factor of increased financial risk. Current structure: no financial risk Risk at 30% debt: Financial risk is roughly half of business risk Risk at 50% debt: Financial risk is the same as business risk Risk at 70% debt: Financial risk is almost two and a half times the company’s business risk. Actual 1981 Debt to Total Capital Ratio 30% 50% 70% T 47. 79% 48% 48% 48% D/E 0. 43 1. 00 2. 33 ?U (business risk) 0. 8 (approx) 0. 8 0. 8 0. 8 ?L (financial risk) 0. 98 1. 22 1. 77 C. How much potential value, if any, can AHP creat for its sharwholders at each of the proposed levels of debt? Increase in the value of the firm that means increase shareholders Benefit. A. What capital structures would you recommend as appropriate for AHP? What are the advantages of leveraging this company? Since the culture of the firm is one of frugality and conservatism, we are suggesting a 30% debt level. This would increase the value of the firm and would be more in line with its competitor’s (Warner-Lambert) debt ratio. AHP’s WACC would be reduced to give it more of a competitive advantage. A 50% or 70% debt capital structure will further enhance the value but poses higher risks. B. What are the advantages and disadvantages of leveraging a company? The advantage of leveraging a company is to increase value of the corporation. Leveraging a company will also increase earnings per share, which will most likely cause the market price of stock to increase. Also, increased stock prices will help to fend off takeover attempts. Other advantages for leveraging a company are the reduction in cost of capital, as well as tax advantage of borrowing. At a Glance advantages: Tax Shield †¢ Extra cash for expansion and stock repurchase †¢ Higher EPS (by repurchase stock) †¢Generate Shareholder wealth by increase the company value The major disadvantage of issuing debt is the increased financial risk of the company. The company may not be able be able to make payments on debt or find new lenders in the future, resulting in a higher risk of bankruptcy. The company’s bond rating may be lowered as well. Finally, the company will be at a higher risk to fluctuation on interest rates. At a Glance Disadvantages: †¢Increases the company risk structure LBO will affect the operational side of the company †¢Potential reverse effe C. How would leverage up affect the companys taxes? †¢Interest is tax-deductable †¢The more company borrows the less pays in Tax. Pro Forma 1981 for Varying Percentages of Debt to Total Capital Actual 1981 30% 50% 70% Sales 4,131. 20 4,131. 20 4,131. 20 4,131. 20 EBIT 954. 80 922. 20 922. 20 922. 2 Interest (2. 30) (52. 70) (87. 80) (122. 9) Profit before taxes 952. 50 869. 50 834. 40 799. 3 Taxes (455. 20) (417. 40) (400. 50) (383. 7) Profit after taxes 497. 30 452. 10 433. 90 415. 6 D. How would the capital markets react to a decision by the company to increase the use of debt in its capital structures? Market values balance sheet differs from accounting balance sheet in numbers. Price Per Share Actual $30. 00 30% 70% $31. 12 50% 50% $31. 89 70% 30% $32. 67 A. How might American Home Products implement a more aggressive capital structure policy? †¢More aggressive capital structure policy = increase of the portion of debt in a firms capital structure †¢Ways to implement it differs in the way company uses the proceeds from new debt issuance Repurchase of stock: Price of the stock goes up. ?Fending off takeover attempts. Offer equity-debt swap to its investors: ?Stock price will increase ?Market infers that the firm is better off Finance expansion: ?Acquisition of Stock. ?Horizontal acquisition. B. What are the alternative methods for leveraging up? Company needs to do financial leverage to its existing resources: †¢money, †¢technology, †¢h uman resource, †¢distribution channel 4. In view of AHPs unique corporate culture, what arguments would you advance to persuade Mr. Laport or his successor to adopt your recommendation? Risk Aversion tax-advantages Share Holders Benefit ?Debt increases the shareholders‘ return on their investment Tight financial Control and Centralization ?Debt protects from potential takeover Conclusion Recommendations: Even though AHP has a very good current financial performance, it should change the financial policy to increase debt ratio at a certain level. To meet the goal of increasing shareholders’ value, AHP should not use its excess cash flow to repurchase its stocks because this is only a temporary solution and may generate serious financial problems in the long run. Instead, AHP should use this excess cash to invest in profitable projects to improve its current products and launch new products that meet current market demands. By doing so, AHP can minimize the business risk, prepare itself for competition and increase sales growth. On the other hands, AHP should increase debt ratio to a certain level that is suitable for its business to increase shareholders’ value. This solution does not bring financial risk to AHP but enable it to minimize business risk. If AHP only concerns about how to increase shareholders’ value and ignores market threats, it might lose its business to its competitors. In conclusion, AHP should change the financial policy to increase debt ratio at a certain level. References: 1. Principles of Corporate Finance by Richard Brealey. 2. Capital Investment and Financial Decisions by Heim Levy and Marshall Sarnat. 3. Fixed-Income Securities: Valuation, Risk Management and Portfolio(The Wiley Finance Series) 4. Investment Valuation: Tools and Techniques for Determining the Value of any Asset, Second Edition by Aswath Damodaran