Answer for Harvord Ahp Case Study

Topics: Finance, Debt, Basic financial concepts Pages: 3 (643 words) Published: May 20, 2012
1. Business risks:
* Too conservation and risk-aversion: avoid much of the risk of new-product development and introduction in the volatile drug industry. * Centralizing complete authority in the chief executive: all expenditures greater than $500 had to be personally approved by William Laporte, even if authorized in the corporate budget; the management from the top is unparalleled in any firm of comparable size. * Excess liquidity and low degree of leverage, conservative capital structure. * DOL=(⊿EBIT/EBIT)/(⊿S/S)

Financial risk:
DFL can reflect financial risks
| Actual 1981| Pro Forma 1981 for|
| | 30% debt| 50% debt| 70% debt|
EBIT| 954.8| 922.2| 922.2| 922.2|
Interest| 2.3| 52.7| 87.8| 122.9|
DFL| 1.0024| 1.0606| 1.1052| 1.1538|
The larger the DFL, the larger the financial risks
Potential value:
The potential value American Home Products can create is the tax shield. Tax shield=Debt*Tax rate=Interest/Interest rate*Tax rate
* 30%: 52.7m/.14*0.48=180.686m
* 50%: 87.8m/.14*0.48=301.029m
* 70%: 122.9m/.14*0.48=421.371m

2. Recommend: 30% debt to Total Capital
Because Warner-Lambert Company was about the same size as AHP and competed in roughly similar lines of business, it had a debt ratio of 32% in 1980. Besides, AHP’s firmly rooted financial conservation, if started with too high debt-equity ratio, it may cause some problems.

| Actual| 30% Debt| 50% Debt| 70% Debt|
DCL| 1.2667| 0.95139| 0.991411| 1.034948|
DFL| 1.0023| 1.06061| 1.10522| 1.15376|
Net income after tax/Debt per year| | 1.18852| 0.71315| 0.509346214| When Net income after tax/Debt per year is larger than1, it means that the company is good at paying off debt. So, recommend 30%

Advantage of leveraging
Enjoy tax shield brought about by debt
Change its too conservative capital structure
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