# American Home Products

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American Home Products
1. How much business risk does AHP face?

How much financial risk would the company face at each of the proposed levels of debt shown in Exhibit 3?
Financial risk is a function of the company’s business risk multiplied by the debt/equity (D/E) ratio. Thus the higher the D/E ratio, the greater the leverage and financial risk. The following table provides the D/E ratios at each proposed level, which indicate the factor of increased financial risk.
Current structure: no financial risk
Risk at 30% debt: Financial risk is roughly half of business risk
Risk at 50% debt: Financial risk is the same as business risk
Risk at 70% debt: Financial risk is almost two and a half times the company’s business risk Current 30% 50% 70%
Debt Level (\$) 13.9 376.1 626.8 877.6
Equity 1472.8 877.6 626.9 376.1
Debt/Equity 0.0094 0.4286 0.9998 2.3334

How much potential value can AHP create for shareholders at each of the proposed levels of debt?
Current Aggregate value of common stock: \$4665.0
Value at 30% debt: 4665.0 + ((376.1 – 13.9) *.48) = \$4839
Value at 50% debt: 4838.9 + ((626.8 – 376.1) *.48) = \$4959
Value at 70% debt: 4959.2 + ((877.6 – 626.8) *.48) = \$5080

2. What capital structure do you think is appropriate for AHP?
Since the culture of the firm is one of frugality and conservatism, we are suggesting a 30% debt level. This would increase the value of the firm and would be more in line with its competitor’s (Warner-Lambert) debt ratio. AHP’s WACC would be reduced to give it more of a competitive advantage. A 50% or 70% debt capital structure will further enhance the value but poses higher risks (see disadvantages below).

The advantage of leveraging a company is to increase value of the corporation. Leveraging a company will also increase earnings per share, which will most likely cause the market price of stock to increase. Also, increased stock

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