A combination of business risk and financial risk shows the risk of an organization’s future return on equity. Business risk is related to make a firm’s operation without any debt whereas financial risk requires that the firm’s common stockholders make a decision to finance it with debt. Business risk can be evaluated volatility in earnings and profits (coefficient of variation of returns on assets and of operating profits). A measure of business risk is also asset beta or unlevered beta. In case of AHP, it is 1.2 (βa) which is very low signifying low business risk for the firm. AHP’s business risk is low mainly because:
1. It has been operating on four main lines of business that bear less uncertainty about product demand. 2. The firm has maintained low leverage regularly. AHP’s cash was about 23% of total assets, which rose constantly since 1978 to 1981;it has maintained enough cash flow to fiancé its daily operations. 3. Also, ROA(return on assets) of AHP was stable, with very low coefficient of variation of 5% (1972-81).(refer exhibit 1) 4. Even, the coefficient variation of Operating profit margin is very low about 3% for 1972-81. (refer exhibit 1) 5. Risk aversion was the most fundamental component of AHP’s culture;consequently, they have conservative approach towards R&D and follow the ‘me-too’ approach towards introduction of new products. Total debt and financial risk have straight correlation with each other and AHP’s total debt increased, so its financial risk would rise. Financial risk is measured by Equity beta of a firm. We see in our calculations that it βe increases as we increase the leverage.
To compute the asset beta, we use the weighted average of equity beta and debt beta. Here we assume the current debt of AHP, which is quite small, has the rating of AAA. The equity value is calculated with current stock price ($30) and number of shares outstanding, while net debt equals debt minutes excess cash ($233m), which results in a negative weight. Getting beta of equity from Re, we could obtain beta of asset (1.2) and Ra (18.58%).
AHP’s value will change after leverage as there will be debt tax shield and financial distress and this change in value would reflect in stock price and thus result in different equity value. The calculation needs the rating of bonds and also the value of debt tax shield and financial distress, which will be done in question 3 &4. Here just give the results of equity value in 3 situations.(Exhibit 1) Thus, the cost of equity is increasing with higher debt ratio, which implies higher risk for shareholders.
Debt ratio| 30%| 50%| 70%|
D+E| 4679.1 | 4678.9 | 4678.9 |
D| 376.1| 626.8| 877.6|
E| 4303.0| 4052.1| 3801.3|
Rd| 13.32%| 13.82%| 14.07%|
Re| 19.04%| 19.32%| 19.62%|
βe| 1.20| 1.23| 1.26|
A capital structure comprised of 30% debt should not have a great effect on AHP's business risk statistic. In fact, the implications of a 30% debt strategy could actually reduce AHP's business risk, while marginally increasing the firm's financial risk. Less debt makes AHP less reliant on the need for growing revenues or sales, because of its lack of financial obligations. The firm's financial risk is the possibility that it could potentially default on its debt by failing to repay principal and interest in a timely manner. From Exhibit 1, it is evident that AHP does not run the risk of presenting a low interest coverage ratio (EBIT divided by interest payments) or a low ratio of cash flows available to pay for debt. Again, a lower percentage of debt reduces this risk and the default outcome. AHP can have tax shield advantage of debt if it uses heavier capital structure.
Firm’s current capital structure: American Home Products is a company with virtually no debt,excess liquidity and an impressive amount of cash on its balance sheet. Under its current leadership,...