American Home Products Corporation
Managing Corporate Capital Investment and Capital Structure
Case 5
American Home Products Corporation
Assess American Home Products ' (AHP) business risk.
THE BUSINESS RISK OF A COMPANY INCLUDES ΒR WHICH IS RELATED TO ITS REVENUE AND OPERATING LEVERAGE WHICH ARISES FROM FIXED COSTS OF PRODUCTION. IN GENERAL, THE PHARMACEUTICAL INDUSTRY HAS A VERY HIGH BUSINESS RISK DUE TO HIGH RISKS AND COSTS THAT ARE ASSOCIATED WITH THE RESEARCH AND DEVELOPMENT OF NEW PRODUCTS. AMERICAN HOME PRODUCTS HAS A LOW BUSINESS RISK IN COMPARISON TO THE INDUSTRY. THIS IS BECAUSE OF THE UNIQUE NATURE OF MIMICKING COMPETITOR 'S PRODUCTS AND MARKETING THEM IN A SUPERIOR MANNER, AHP AVOIDS LARGE R&D EXPENDITURES. BECAUSE THE R&D REPRESENTS A LARGE AMOUNT OF FIXED COSTS TO THE INDUSTRY, ALL OTHER FACTORS BEING EQUAL, THE RISK WILL BE LOWER. SECONDLY THE FRUGALITY OF THE COMPANY AIDS IN AVOIDING UNNECESSARY FIXED COSTS, LIKEWISE AIDING IN THE DECREASED BUSINESS RISK. THIRDLY THE COMPANY HAS OVER 1500 PRODUCTS WHICH EACH HAVE A DIFFERENT REVENUE STREAMS, THIS DIVERSIFICATION ALSO DECREASES THE VARIABILITY OF REVENUE TO THE CORPORATION.
2. Assess AHP 's financial risk at each of the proposed levels of debt shown in case Exhibit 3. What bond rating would you expect at each level?
BECAUSE A COMPARABLE COMPANY, WARNER LAMBERT, HAS 32.4% DEBT AND 5X INTEREST COVERAGE RATIO WE CAN USE THIS AS A BENCHMARK TO EVALUATE THE BOND RATING FOR AHP. SINCE THE DEBT OF AHP WAS 30%, AND AHP ALSO HAD A TIMES INTEREST EARNED RATIO OF 415, WE CAN CONCLUDE THAT THE BOND RATING WILL BE HIGHER.
TABLE 1.1
ACTUAL
30%
50%
70%
DEBT LEVEL ($)
13.9
376.1
626.8
877.6
DEBT/CAP
0.94
30
50
70
TIE
415
17.5
10.5
7.5
EXPECTED BOND RATING
AAA
AAA
AA
A
3. How much value can AHP create for its shareholders at each of the proposed levels of debt under M&M 63? How would your answer change if personal taxes were incorporated in the analysis? Explain.
TABLE 1.2
CURRENT
30% DEBT
Case 5
American Home Products Corporation
Assess American Home Products ' (AHP) business risk.
THE BUSINESS RISK OF A COMPANY INCLUDES ΒR WHICH IS RELATED TO ITS REVENUE AND OPERATING LEVERAGE WHICH ARISES FROM FIXED COSTS OF PRODUCTION. IN GENERAL, THE PHARMACEUTICAL INDUSTRY HAS A VERY HIGH BUSINESS RISK DUE TO HIGH RISKS AND COSTS THAT ARE ASSOCIATED WITH THE RESEARCH AND DEVELOPMENT OF NEW PRODUCTS. AMERICAN HOME PRODUCTS HAS A LOW BUSINESS RISK IN COMPARISON TO THE INDUSTRY. THIS IS BECAUSE OF THE UNIQUE NATURE OF MIMICKING COMPETITOR 'S PRODUCTS AND MARKETING THEM IN A SUPERIOR MANNER, AHP AVOIDS LARGE R&D EXPENDITURES. BECAUSE THE R&D REPRESENTS A LARGE AMOUNT OF FIXED COSTS TO THE INDUSTRY, ALL OTHER FACTORS BEING EQUAL, THE RISK WILL BE LOWER. SECONDLY THE FRUGALITY OF THE COMPANY AIDS IN AVOIDING UNNECESSARY FIXED COSTS, LIKEWISE AIDING IN THE DECREASED BUSINESS RISK. THIRDLY THE COMPANY HAS OVER 1500 PRODUCTS WHICH EACH HAVE A DIFFERENT REVENUE STREAMS, THIS DIVERSIFICATION ALSO DECREASES THE VARIABILITY OF REVENUE TO THE CORPORATION.
2. Assess AHP 's financial risk at each of the proposed levels of debt shown in case Exhibit 3. What bond rating would you expect at each level?
BECAUSE A COMPARABLE COMPANY, WARNER LAMBERT, HAS 32.4% DEBT AND 5X INTEREST COVERAGE RATIO WE CAN USE THIS AS A BENCHMARK TO EVALUATE THE BOND RATING FOR AHP. SINCE THE DEBT OF AHP WAS 30%, AND AHP ALSO HAD A TIMES INTEREST EARNED RATIO OF 415, WE CAN CONCLUDE THAT THE BOND RATING WILL BE HIGHER.
TABLE 1.1
ACTUAL
30%
50%
70%
DEBT LEVEL ($)
13.9
376.1
626.8
877.6
DEBT/CAP
0.94
30
50
70
TIE
415
17.5
10.5
7.5
EXPECTED BOND RATING
AAA
AAA
AA
A
3. How much value can AHP create for its shareholders at each of the proposed levels of debt under M&M 63? How would your answer change if personal taxes were incorporated in the analysis? Explain.
TABLE 1.2
CURRENT
30% DEBT