Cash Flow of Products

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  • Topic: Stock, Financial ratio, Finance
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American Home Products Corporation
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? A combination of business risk and financial risk shows the risk of an organization’s future return on equity. Business risk is related to make a firm’s operation without any debt, whereas financial risk requires that the firm’s common stockholders make a decision to finance it with debt. a) American Home Products has been operating on four main lines of business that are less uncertainty about product demand; for example, one of its business lines is food products because whenever people buy foods. It means that AHP’s business risk is low. As mentioned above, if a firm does its operation activities regularly without leverage, it means that its business risk is not significant high. Thus, ratio of cash to total assets is calculated by following:

Figure 1 Proportion of cash and total assets, 1976-1981 ($ in millions)| | | | | | | |
 | 1981| 1980| 1979| 1978| 1977| 1976|
Cash| 729.1 | 593.3 | 493.8 | 436.6 | 322.9 | 358.8 | Total Assets| 2,588.5 | 2,370.3 | 2,090.7 | 1,862.2 | 1,611.3 | 1,510.9 | Proportion| 28.2%| 25.0%| 23.6%| 23.4%| 20.0%| 23.7%|

According to Figure 1, AHP’s cash was about 23% of total assets, rose constantly since 1978 to 1981, and reached 28.2% in 1981; thus, it has enough cash flow to finance its daily operation.
Also, return on assets can show that a firm’s ability to cover its operating cost by generating income. According to the calculation below, American Home Products Corporation’s ROA was stable and approximately 19.2 % in 1981; consequently, AHP earned sufficient amount of income to cover its operating cost. Figure 2 Return on Assets of Amercan Home Products Corporation, 1972-1981 ($ in millions)| | | | | | | | | | | |

 | 1981| 1980| 1979| 1978| 1977| 1976| 1975| 1974| 1973| 1972| Net Income| 497.3 | 445.9 | 396.0 | 348.4 | 306.2 | 277.9 | 250.7 | 255.6 | 199.2 | 172.7 | Total Assets| 2,588.5 | 2,370.3 | 2,090.7 | 1,862.2 | 1,611.3 | 1,510.9 | 1,390.7 | 1,241.6 | 1,126.0 | 1,042.0 | ROA| 19.2%| 18.8%| 18.9%| 18.7%| 19.0%| 18.4%| 18.0%| 20.6%| 17.7%| 16.6%|

Add to these above explanations, Exhibit 1 shows that AHP’s peak annual growth in sales was 14.1% in 1978 and compare to it, annual growth in sales decreased by 5.3% in 1981; as a result, it became disadvantage to AHP because consumers started to interest into competitors’ products. Risk aversion was the most fundamental component of AHP’s culture; consequently, they prefer to acquire or take license of previously developed goods or produce similar products with its competitors rather than to develop new-products. Although it seems to save R&D expenses, acquisition cost or a cost of time response to steal other’s innovation would be still appeared. Thus, AHP should try to improve its sales. b) Financial risk is related to business risk, so we measured NOPAT, ROIC, ROE whose uncertainty future can determine a firm’s business risk in Figure 3. Figure 3 Pro Forma 1981 Results for Alternative Capital Structures ($ in millions except ratios)| |

 |  | Pro Forma 1981 for|
 | Actual 1981| 30% Debt to Total Capital| 50% Debt to Total Capital| 70% Debt to Total Capital| Total Debt| 13.9 | 376.1 | 626.8 | 877.6 | Net Worth| 1,472.8 | 877.6 | 626.9 | 376.1 | Required Capital| 1,486.7 | 1,253.7 | 1,253.7...
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