American Home Products
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 Current30%50%70% Debt Level ($)13. 9376. 1626. 8877. 6 Equity1472. 8877. 6626. 9376. 1 Debt/Equity0. 00940. 42860. 99982. 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. + ((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?
American Home Products Essay Example
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).
What are the advantages and disadvantages of leveraging a company? 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 prices will help to fend off takeover attempts. Other advantages for leveraging a company is the reduction in cost of capital, as well as tax advantages of borrowing. The major disadvantage of issuing debt is the increased financial risk of the company.
The company may not be able to make payments on debt or find new lenders in the future, resulting in a higher risk of bankruptcy. The company’s bond ratings may be lowered as well. Finally, the company will be at a higher risk to fluctuations of interest rates. 3. How might AHP implement a more aggressive capital structure policy? What are the alternative methods for leveraging up? AHP may implement a more aggressive (leveraged) capital structure policy by issuing short-term debt securities and use those proceeds to repurchase stock.
While there will be higher transaction costs of rolling over maturing bonds, we feel the risk-adverse management will prefer the higher costs versus the commitment of long term bonds. Long-term bonds make it difficult to reduce leverage if the firm is performing lower than expected. AHP may also offer equity for debt swaps, such as exchanging common stock for bonds. Additionally, AHP may finance new assets and expansions with debt rather than equity.