“American Home Products” State clearly all assumptions that you make and defend their choices whenever possible. 1. How much business risk does AHP face? How much financial risk would AHP face at each of the proposed levels of debt shown in case Exhibit 3? Answer these questions by computing and evaluating the asset beta and the equity beta. Assume that the current RE = 18.33% and a market risk premium of 5%. The 10y Treasury bond yield in January 1981 was 12.57%. Here is the spread-over-Treasury and the debt beta for different credit ratings.
Rating Spread Cost of Debt Beta(d)
AAA AA A BBB BB B 0.75% 1.25% 1.50% 5.00% 7.00% 9.00% 13.32% 13.82% 14.07% 17.57% 19.57% 21.57% 0.15 0.25 0.25 0.25 0.25 0.25
2. What is the current capital structure of American Home? Evaluate its benefits/disadvantages. 3. How much potential value, if any, can AHP create for its shareholders at each of the proposed levels of debt in Exhibit 4? To answer some of these questions, use the following data sheet with information about important variables according to firm’s credit ratings:
S&P Medians (79-81) Debt Ratio Coverage=EBIT/Interest Prob.(Bankruptcy)
AAA 17% 18.25 0.16%
AA 24% 8.57 0.72%
A BBB BB B 30% 39% 48% 59% 6.56 3.82 3.27 1.76 1.32% 4.78% 15.68% 36.65%
4. What capital structure would you recommend as appropriate for AHP? Talk about the benefits and drawbacks of your proposal. How would the capital markets react to a decision by the company to increase the use of debt in its capital structure?