American Home Products

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1. How much business risk does AHP face?

How much financial risk would the company 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 indicate 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

Current30%50%70%
Debt Level ($)13.9376.1626.8877.6
Equity1472.8877.6626.9376.1
Debt/Equity0.00940.42860.99982.3334

How much potential value can AHP create for shareholders at each of the proposed levels of debt? Current Aggregate value of common stock: $4665.0
Value at 30% debt: 4665.0 + ((376.1 – 13.9) *.48) = $4839 Value at 50% debt: 4838.9 + ((626.8 – 376.1) *.48) = $4959 Value at 70% debt: 4959.2 + ((877.6 – 626.8) *.48) = $5080

2. What capital structure do you think is appropriate for AHP? 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 (see disadvantages below).

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...
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