1. 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? (See Exhibits 1 and 2 )
American Home Products currently has low business risk due to the conservative nature of their business. They piggyback on first movers to lower their research and development costs. They excel in marketing therefore they concentrate on outselling their competitors. Also, they have low business risk because they are diversified among four product lines: prescription drugs, over the counter drugs, food products, and housewares producing over 1500 products. Three of American Home Products’ product lines (prescription drugs, over the counter drugs, and food products) are within the defensive industries which mean they have little sensitivity to the business cycle. These industries outperform others even when the economy is bad. In addition, through diversification of manufacturing a variance of product lines, if one product line were to experience a decrease in sales, the other lines should theoretically pick up the slack. AMH appears to be a healthy company when looking at its financial statements. AMH’s net worth (total assets-total debt) is 1,472.8 million. They have an excess cash of $233 million. Their ROE, profit margin, ROA, and A/R receivable turnover days all illustrate AMH’s financial strength indicating that they can rapidly generate cash to sustain their current growth rate, at 30.3%, 11.7%, 18.72%, AND 49.73 days respectively. AMH outperforms their industry in all above mentioned ratios. (See Exhibit #1). However it should be noted that their sales have decreased 5.3% from 14.1% in 1978 to 8.8% in 1981. This foreshadows possible risk in the future. This is why AMH is rethinking their conservative and “tightfisted spending” business approaches.
Currently AMH’s financial performance is strong. (Refer to Exhibit #2). Their high return on equity (ROE) at 30.3% illustrates how much profit the company is generating with the shareholder’s investments. In addition, they have low debt to equity and low debt to asset (debt) ratios both at .005. This further signals their financial strength. From the debt ratios we see that a change decrease in sales or an increase in interest payments would not affect AMH because they have plenty of free cash flow. However the debt ratios also indicate that management may not be responsibly growing the company through the use of leverage and forgoing many opportunities for future growth. Therefore when you compare the increase of debt alternatives AMH has you can see an increase in debt to equity and debt to debt to asset ratios. For example the debt to equity ratio increases at each level, 30%, 50%, and 70%, to .17,.32, and .513 respectively. The same is true for the debt to asset ratio. It increases to .15,.24,and .34 at 30%,50%,and 70% respectively. Although these could signal financial solvency issues, the industry’s debt to equity ratio is .32, and their debt to asset ratio is .24. This is consistent with the AMH’s 50% debt alternative option. However, the increase of debt adds value to the company. This is best illustrated when looking at the earnings per share (EPS) and dividend payout ratio. As the debt increases so do both of the above mentioned ratios. EPS consistently increases from 3.18 with no added leverage to 3.33 at 30%, 3.41 at 50%, and 3.49 at 70%. The DPS ratio increase from .597 at no additional leverage to .602 at 70%. Shareholders often interpret an increase in dividends as an increase in confidence of future growth within the company.
AMH is financially strong; however, the provided statistics show it would be best for the company to increase its leverage to a certain level to add more...