American Home Products Corporation

898 WordsJan 19, 20084 Pages
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…show more content…
THIS IS DUE TO THE INTEREST TAX SHIELD OF THE DEBT. BECAUSE OF THE DIFFERENCE IN TAX RATES FOR INTEREST PAYMENTS (ORDINARY INCOME) AND DIVIDENDS (15% - 25%) AS DEBT IS ADDED TO THE STRUCTURE THE PAYMENTS ARE MADE TO INVESTORS IN THE FORM OF INTEREST PAYMENTS. INTEREST PAYMENTS ARE TAXED AT ORDINARY INCOME WHICH SHOULD BE HIGHER THAN 25%. THE VALUE OF THE FIRM WILL DECREASE UNDER THIS SCENARIO. 4. What capital structure would you recommend as appropriate for AHP? Are there any other sources of value, (other than the tax benefits), to AHP 's shareholders from a leverage increase? What are the advantages and disadvantages of levering this company? A 30% DEBT LEVEL WOULD INCREASE THE VALUE AND IS APPROPRIATE CONSIDERING THE CULTURE OF THE FIRM. WE FEEL THAT A DRASTIC INCREASE IN DEBT WILL HAVE AN ADVERSE AFFECT ON THE CORPORATE CULTURE AND RECOMMEND A MODERATE CHANGE, RATHER THAN A DRASTIC ONE. AN EXTREME CHANGE SUCH AS 50% OR 70% INCREASE IN DEBT WILL ENHANCE THE VALUE BUT IS LESS LIKELY TO BE ACCEPTED BY CONSERVATIVE MANAGEMENT. THE INCREASE IN STOCK PRICE ASSUMES THAT AHP IS PURCHASING OUTSTANDING SHARES WITH THE NEWLY ISSUED DEBT. WE CAN SOLVE FOR THIS INCREASE BY DIVIDING THE AGGREGATE MARKET VALUE OF COMMON STOCK, AS MEASURED IN

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