American Home Products Corporation - Case Study

Write UP

On

AMERICAN HOME PRODUCTS CORPORATION:

Company Overview

Background Information:

American Home Products Corporation (AHP), is a pharmaceutical company. The company was based in Madison, New Jersey, USA. They were known for manufacturing the over-the-counter (OTC) drugs Robitussin and the analgesic Advil (ibuprofen), as well as the prescription drugs Premarin and Effexor, which both boast over US$3 billion in sales annually.

American Home Product Corporation (AHP), a highly growing American company, has four business lines: prescription drugs, packaged drugs, food products, house wares and household products. For a quite long time, AHP has applied a tight financial control and maintained an aggressive capital structure policy. Its mission is to make money for its stockholders and to maximize profits by minimizing costs. It has been able to finance internally its growth while paying a very high portion of its earning to its shareholders (60%)

Currently, AHP seems to have no business risk but may face a certain risk in the long run. Based on the ratios shown on the attached sheet, AHP should not worry about business risk since its working capital is very healthy and have cash excess. The high ROA, high profit margin, low current-to-asset ratio and collection days show that AHP can generate cash quickly, thus it can maintain current high growth rate. However, it's decreasing annual sales growth shows that it faces future risk of losing market shares in all its business lines if it does not foresee competition and continue to focus on increasing stockholders' value. AHP's current financial performance is very good since it has high ROE, high quick ratio, low debt-to-equity ratio and low debt-to-asset ratio. However, the pro forma of different debt ratios show that if AHP increases debt ratio, it will face a financial risk of increased debt-to-equity and debt-to-asset ratios. In other words, it will face solvency problems in long terms. AHP also face liquidity problems since the quick ratios decrease when the debt ratios increase. In contrast, shareholders' value increases when debt ratios increase. EPS increases. The dividend payout ratio also increases similarly, the dividend yield as well. It seems that the company can increase shareholders' value by increasing debt ratios. Even though AHP has a very good current financial performance, it should change the financial policy to increase debt ratio at a certain level to meet the goal of increasing shareholders' val

Major Focus Areas of the Case:

 Capital structure

 Debt management

 Financial strategy

Financial analysis:

 At the end of 1980, AHP had almost no debt and a cash balance equal to 40% of its net worth

 "I just don't like to owe money", said William F. Laporte, AHP chief executive, when asked about his company's almost debt-free balance sheet and growing cash reserves.

 Mr. Laporte had taken over as chief executive of American Home Products in 1964. Throughout 17 subsequent years of his tenure Mr. Laporte has not changed his opinion of debt financing and AHP's abstinence from debt continued, while the growth in its cash balances outpaced impressive growth in both sales and earnings.

 At the end of 1980, AHP had almost no debt and a cash balance equal to 40% of its net worth.

AHP's Performance :

 Stable, consistent growth and profitability... increased sales, earnings, and dividends for 29 consecutive years through 1981.

In 1981, after 17 years as chief executive, Mr. Laporte was approaching retirement, and analysts speculated on the possibility of a more aggressive capital structure policy.

Questions & Answered

A. How much business risk does America Home Products face?

AHP has a low business risk

B. How much financial risk would AHP 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 indicates 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.

Actual 1981 Debt to Total Capital Ratio

30% 50% 70%

T 47.79% 48% 48% 48%

D/E 0.43 1.00 2.33

βU (business risk) 0.8 (approx) 0.8 0.8 0.8

βL