Case 1:American Home Products 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? American Home Products offers a variety of products spread over 4 product lines. This allows the company to attract many consumers and if one product line does have a decline in sales, the company still has 3 other product lines to make up for the lost profit. The 4 product lines are prescription drugs, over the counter drugs, food products and housewares. These are very common …show more content…
What are the advantages of leveraging this company? The disadvantages? How would leveraging up affect the company’s taxes? How would the capital markets react to a decision by the company to increase the use of debt in its capital structure? We would recommend the capital structure with 30% debt. This is because with 30% debt, they would be able to repurchase 19.8 million shares outstanding as well as save 37.8 million in taxes. EBIT is high in this company, and because of this, financial leverage will raise EPS and ROE. However, variability also increases as financial leverage increases, so the company would not want to take on too much debt and become very risky. The advantages of leveraging the company is the money they would save on the tax shield, higher EPS, higher dividend payouts, and extra cash available for expansion and repurchase of shares. The disadvantages is the increase of company risk and if the market experiences a recession, they may be unable to pay off their debt as well as have no money for shareholders. Leveraging the company would affect taxes because interest is tax deductible. Therefore, the more debt American Home Produces takes on, the less the company will have to pay in taxes. Also, when leveraging up there is tax savings the company will receive due to the interest tax shield. 30% debt tax savings: 0.48 X $376.1 = $180.53 50% debt tax savings: 0.48 X $626.8 = $300.86 70%
Our company will plan to finance our strategy principally through issuing stock and cash flows from operating activities generated from the company’s normal business functions. It is undesirable for our strategy to issue debt because we would like to stay away from interest payments. Our company anticipates our debt to equity leverage ratio to be around 0.5.
Sterling Household Products Company manufactured and marketed a wide variety of consumer goods products which were sold domestically as well internationally. Despite having great products and being positioned well in the industry, Sterling’s growth prospects were limited. Sterling’s decision to acquire the germicidal, sanitation and antiseptic production unit of Montagne Medical Instruments Company could provide the much needed growth. Furthermore, the division was well aligned with Sterling’s existing operations, helping Sterling diversify its business without compromising on
The company position is strong enough so its better that company should use debt financing instead of equity financing.
If HCA chooses to remain at the current debt ratio take on a lower rating, suspicion might arise among investors. In both cases opportunities exist as well as consequences. The advantages and disadvantages are outlined in Scenario 1 - 3.
Aside from the two aforementioned proposals the company can raise its leverage in other ways. By conducting DuPont analysis and understanding operating leverage we see that purchasing fixed assets and decreasing stockholder’s equity will raise the equity multiplier and the firm’s operating leverage. In this instance we recommend against this approach as the firm already has a large amount of excess cash above what they require to fund new positive NPV projects and purchase new assets. Investors would rather see their capital returned to them in the form of share repurchases and dividends as it is evident by the company’s cash stockpile that they can
Higher leverage is very likely to create value for a firm considering capital structure change by exerting financial discipline and more efficient corporate strategy changes.
Increased leverage would increase the risk for the shareholder. This is due to the fact that an increased amount of debt would increase the financial return that investors expect. For example, if a company has no debt and posts better than expected earnings, the equity holder would get all of this benefit. If the company had some debt and posted better than expected earnings, the bond holders would get a fixed payment as usual, and shareholders would still enjoy increased profits; the problem arises if worse than expected profits were shown by Kelly Services. If Kelly Services had no debt and posted bad earnings, then the equity bears all the risk in that situation. However, if Kelly
Grant Nauta AHP Case Study Because American Home Products (AHP) currently operates with virtually no debt, their financial risk is very small. This shifts the burden heavily towards business risk. A porter’s five forces analysis is appropriate to determine the exact levels of business risk for American Home Products. First, the threat of substitutes is a risk that AHP cannot afford to ignore. Because they spend very little on Research and Development, and have to rely on their marketing to catch up to competitors, they always seem to be a step behind their competitors. In the industries that AHP operates, switching costs are very low and consumers based on anything from price to overall sentiment. Also, if a competitor markets a product
With the three debt instruments in the case, hundreds of millions of dollars would become readily available to the company and be at their disposal. Each of the financing opportunities provides their own money in different forms. Great companies need these different financing ideas to
When analyzing which debt financing option CPK should choose, the weight average cost of capital (WACC) will provide an approximation on how much CPK must earn in order to satisfy the amount financed. The values of WACC for the actual, 10%, 20%, and 30% options can be found in Appendix A. It appears that the higher the financial leverage, the lower the WACC will be. Take for instance if CPK chooses a 30% debt to capital situation, the ROE will be 11.1 % with a 9.2% WACC. In contrast, at the actual value, the ROE is 9% with the WACC being 9.5% and could pose badly for CPK. As long as CPK is comfortable with the high risk of a 30% debt to capital ratio, then it would be the most beneficial in terms of adding economic value to the company, and for the shareholders, while providing a high financial leverage.
Although the increased leverage decreases the amount of earnings available to stock holders from 496.9 million to 451.7 million for a total of 45.2 million dollars, it has a positive affect for the company’s tax structure. It actually reduces the company’s tax liability by 83 million dollars! Without the debt they have to pay 952.5 million dollars in taxes. However after an increase of 30% leverage, the new tax liability is 869.5 million dollars.
In general, the lower the company's reliance on debt for asset formation, the less risky the company is since excessive debt can lead to a very heavy interest and principal repayment burden. This is demonstrated through statistics such as high financial risk, low interest coverage ratios, and high debt ratios. However, when a company chooses to forgo debt and rely largely on equity, as in the case of AHP, the company does so at the expense of a tax reduction effect supplied by interest payments. Thus, a company has to consider both risk and tax issues when deciding on an optimal debt ratio.
Generally, firms can choose among various capital structures in order to maximize overall market value of the company. It is proposed however, that
It seems then that companies should fully leverage the company or a least come close to doing so but there is a probability that the company enters financial distress as its leverage (D/E) increases. Financial distress can be very costly for companies, and the cost for this scenario is shown in the current market value of the levered firm's securities. Investors factor the potential for future distress into their assessment of the present value (this is where PV of distress costs is subtracted from un-levered company value and the PV of the tax-shield.) The value for the costs
Leveraging business carries some specific benefits that don 't escort different ways of business finance. First, leveraging a business carries some risks, however the