American Home Products Case
American Home Products Case Write-Up
1.
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. Business risk can be evaluated volatility in earnings and profits (coefficient of variation of returns on assets and of operating profits). A measure of business risk is also asset beta or unlevered beta. In case of AHP, it is 1.2 (βa) which is very low signifying low business risk for the firm.
AHP’s business risk is low mainly because: 1. It has been operating on four main lines of business that bear less uncertainty about product demand. 2. The firm has maintained low leverage regularly. AHP’s cash was about 23% of total assets, which rose constantly since 1978 to 1981;it has maintained enough cash flow to fiancé its daily operations. 3. Also, ROA(return on assets) of AHP was stable, with very low coefficient of variation of 5% (1972-81).(refer exhibit 1) 4. Even, the coefficient variation of Operating profit margin is very low about 3% for 1972-81. (refer exhibit 1) 5. Risk aversion was the most fundamental component of AHP’s culture;consequently, they have conservative approach towards R&D and follow the ‘me-too’ approach towards introduction of new products.
Total debt and financial risk have straight correlation with each other and AHP’s total debt increased, so its financial risk would rise. Financial risk is measured by Equity beta of a firm. We see in our calculations that it βe increases as we increase the leverage.
To compute the asset beta, we use the weighted average of equity beta and debt beta. Here we assume the current debt of AHP, which is quite small, has the rating of AAA. The equity value is calculated with current stock price ($30) and number of shares outstanding, while net debt equals
1.
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. Business risk can be evaluated volatility in earnings and profits (coefficient of variation of returns on assets and of operating profits). A measure of business risk is also asset beta or unlevered beta. In case of AHP, it is 1.2 (βa) which is very low signifying low business risk for the firm.
AHP’s business risk is low mainly because: 1. It has been operating on four main lines of business that bear less uncertainty about product demand. 2. The firm has maintained low leverage regularly. AHP’s cash was about 23% of total assets, which rose constantly since 1978 to 1981;it has maintained enough cash flow to fiancé its daily operations. 3. Also, ROA(return on assets) of AHP was stable, with very low coefficient of variation of 5% (1972-81).(refer exhibit 1) 4. Even, the coefficient variation of Operating profit margin is very low about 3% for 1972-81. (refer exhibit 1) 5. Risk aversion was the most fundamental component of AHP’s culture;consequently, they have conservative approach towards R&D and follow the ‘me-too’ approach towards introduction of new products.
Total debt and financial risk have straight correlation with each other and AHP’s total debt increased, so its financial risk would rise. Financial risk is measured by Equity beta of a firm. We see in our calculations that it βe increases as we increase the leverage.
To compute the asset beta, we use the weighted average of equity beta and debt beta. Here we assume the current debt of AHP, which is quite small, has the rating of AAA. The equity value is calculated with current stock price ($30) and number of shares outstanding, while net debt equals