1. Describe AHP’s (i) business operations (ii) corporate culture and (iii) performance record. Ans.
Business Operations: American Home Products Corporation has four main business lines: prescription drugs, packaged drugs, food products, housewares, and household products. Consumer products included a wide variety of well-known brand names like Anacin, Preparations H etc. Its largest and most profitable business – prescription drugs- included sizable market shares in tranquilizers, oral contraceptives etc. Its success was built on marketing expertise. Corporate Culture: There were several features of AHP’s unique corporate culture. First was reticence which was proved by the fact that the Wall Street analysts had ranked AHP last in corporate communicability among 21 drug companies. Second was tight financial control. All expenditures greater than $500 had to be approved by the CEO. Third was its risk-aversion. Most of its new products either were acquired or licensed after their development by other firms or they were copies of new products introduced by competitors. Fourth was its long-standing policy of centralizing authority in the chief executive. Performance Record: AHP was successful in showing impressive performance results. Its financial performance was characterized by stable, consistent growth, and profitability. It had high quick ratio, low debt-to-equity ratio, and high ROE. Return on equity had increased from 25% in 1960s to 30% in 1980s. AHP’s six fold growth in earnings per share had pushed the value of its stock by a factor of three. It had been able to finance internally its growth while paying a very high portion of its earning to its shareholders (60%). However, it can be seen that shareholders’ value increases when debt ratios increase. EPS increases from $3.18 to $3.49. The dividend payout ratio also increases from 0.597 to 0.602. Similarly, the dividend yield from 0.063 to 0.070. It seems that the company can increase shareholders’ value by increasing debt ratios.
2. Assess AHP’s business risk.
Ans. The business risk of a company depends upon β which is related to its revenue and operating leverage which arises from fixed costs of production. In general, the pharmaceutical industry has a very high business risk due to high risks and costs that are associated with the research and development of new products. American Home Products has a low business risk in comparison to the industry. This is because of the unique nature of mimicking competitor’s products and marketing them in a superior manner, AHP avoids large R&D expenditures. Because the R&D represents a large amount of fixed costs to the industry, all other factors being equal, the risk will be lower. Second, the frugality of the company aids in avoiding unnecessary fixed costs, likewise aiding in the decreased business risk. Third, the company has over 1500 products and each has different revenue streams, this diversification also decreases the variability of revenue to the corporation. They also finance most of its growth internally, keeping debt-to-capital ratio pretty low.
3. Assess AHP’s financial risk at each of the proposed levels of debt shown in Exhibit 3. What bond rating would you expect at each level? Ans. Debt-to-capital ratio and interest coverage ratio can be used to asses a business’s risk. a) 30% debt level: Coverage ratio= EBIT/Interest=954.8/2.3=415.13 b) 50% debt level: Coverage ratio= EBIT/Interest=922.2/52.7=17.50 c) 70% debt level: Coverage ratio= EBIT/Interest=922.2/122.9=7.50
The benchmark company is Warner-Lambert which has a debt-to-capital ratio of 32.4% and interest coverage ratio of 5.0. Its bond rating is AAA currently but some analysts believe that it is on the verge of being downgraded to AA. Given this benchmark, the bond rating of AHP would stay at AAA at least till 50% debt level. At 70% debt level, it might be on the verge of being...