American Home Product (AHP) Case Essay

1278 Words Jul 6th, 2013 6 Pages
American Home Products (AHP) has established a strong track record of revenue growth and return on equity over the past decade, producing a host of products in four separate business lines: prescription drugs, packaged drugs, food products, and housewares/household products. AHP’s distinctive culture emphasizes conservatism, cost control and risk aversion. AHP’s corporate structure also concentrated most decision-making authority with the incumbent chief executive, William F. Laporte. This approach and the results that followed has led to popularity amongst investors, with Laporte had stating that “a corporation’s primary mission is to make money for its stockholders and maximize profits by minimizing costs.”
In line with the corporate
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We used 20% of equity value as the cost of financial distress. For measuring leverage, the case gave us book values as found on the balance sheet. The debt to equity can also be calculated using market values. The market value of debt is usually more difficult to obtain directly, since very few firms have all their debt in the form of bonds outstanding trading in the market. Using market value is more realistic as it takes into account prevailing conditions, which are relevant for the marginal decision. Since however that information is not available, we took the approach of assuming book value of debt is equal to market value. Even though the case mentioned that repurchases of stock at $30 per share and that interest rate is 14%, we know that as debt to equity ratio changes these figures will also change. As debt increases, interest rate will also rise, as investors require higher returns for increased risks. The share buyback should also boost earnings per share with should lead to an increased price.
Approach
To evaluate the economics of increased leverage, determined two key numbers in the spirit of the Adjusted Present Value (APV) technique: the present value of the tax savings generated, and the cost of financial distress caused by the increased risk of default. We calculated the present value of the tax-shield is calculated using the formula: tax rate × BV of Debt, assuming that the discount rate and the debt’s interest rates are equal. For the risk

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