Case 1：American Home Products
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 Products offers a variety of products spread over 4 product lines. This allows the company to attract many consumers and if one product line does have a decline in sales, the company still has 3 other product lines to make up for the lost profit. The 4 product lines are prescription drugs, over the counter drugs, food products and housewares. These are very common household items and although there is a possibility the company will not perform well, even during an economic recession, these types of products will still need to be purchased by consumers.
Their current business risk is low, they are able to market their products effectively and focus on selling better than competitors. Therefore, there is no reason to assume profits will be low or that investors will not be paid. Also, the company has kept a consistently high amount of cash as an asset throughout 1976-1981, indicating that business risk is low and the company has the cash flow to easily pay obligations with high net working capital. Sales have also been increasing steadily and the company has had rising EPS and dividend payouts over the years, which means that shareholders have been getting paid more each year.
As debt increases from 30% to 70%, financial risk increases because the more debt the company has, the higher risk there is that they will be unable to pay back the debt owed. However, as debt increases, it is more profitable to shareholders because there are fewer shares outstanding and therefore less of the dividends to be distributed between shareholders. Financial risk can be determined by the company’s ability to repay the interest owed on debt.
30% debt: Interest cover ratio = EBIT / Interest expense
= $922.2 / $52.7
50% debt: Interest cover ratio = $922.2 / $87.8
70% debt: Interest cover ratio = $922.2 / $122.9
As the previous calculations show, the more debt the company has the higher the financial risk. When the interest cover ratio is the highest, at 30%, the company can easily repay their interest expense debt 17.5 times with their current earnings. However, when the debt is at 70%, the company could only pay the interest expense 7.5 times, meaning there is a higher financial risk.
Potential value for shareholders depends on the firm value and dividend payments. If the value of the firm increases, this creates value for shareholders.
First, we need to find the value of the unlevered firm:
VU = [EBIT X (1 – TC )] / RU
Required return the company must provide shareholders=RU
D1 = dividend per share in 1981
P0 = value of one share in 1981
g= growth of EPS in 1981
RU=D1 / P0 + g
= $1.90 / $30 + 0.12
VU=[$954.8 X (1-0.48)] / 0.183
At 30% debt: VL=Vu + (Tc X D)
=$2713.09 + (0.48 X $376.1)
Value added to shareholders at 30% debt: $2893.62-$2713.09=$180.53
At 50% debt: VL=Vu + (Tc X D)
=$2713.09 + (0.48 X $626.8)
Value added to shareholders at 30% debt: $3013.95-$2713.09=$300.86
At 70% debt: VL=Vu + (Tc X D)
=$2713.09 + (0.48 X $877.6)
Value added to shareholders at 30% debt: $3134.34-$2714.09=$420.25
The calculations show that as debt increases, the value to shareholders also increases. The EPS and dividends per share that shareholders receive also increases as debt rises, but as EPS rises,...
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