Case Analysis: Introduction to Debt Policy & Value
1. How much business risk does American Home Products face? How much financial risk would American Home Proudest 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 proposed levels of debt?
β L = β U [1 + D/E (1-T)]
Where β L is the leveraged beta, β U is the unleveraged beta, D/E is the debt to equity ratio, and T is the tax rate.
The equation above can be used to separate the financial risk (β L) of a levered firm from its business risk (β U).
RE = Rf + β U (Rm - Rf)
Where RE is the required rate of ...view middle of the document...
Research and development expenditure is a big portion of a pharmaceutical company’s fixed expenses. All things being equal, American Home Products had a relatively lower risk compare to other pharmaceutical companies.
3. The company had over 1500 products in four lines of business, which helped the company to diversify its revenue streams.
P = D1/ (RE – g)
RE = D1/P + g
Where RE is the required rate of return on equity, D1 is the dividend per share, P is the stock price, and g is the growth rate.
RE = 1.90/30.00 + 0.12
RE = 0.1833 or 18.33%
One way to access the financial risks American Home Products would face at each of the proposed level is looking at the company’s bond rating by using Warner-Lambert Company as a benchmark. Warner-Lambert Company had a profit margin of 5.5% and 5 times interest coverage. The table below summarizes a few of the key ratios at each of the proposed level of debts.
Ratios | | Actual | 30% Debt | 50% Debt | 70% Debt |
Profit margin (profit after tax/sales) | | 12.04% | 10.94% | 10.50% | 10.06% |
Return on equity | | 33.74% | 51.47% | 69.15% | 110.40% |
Interest coverage | | 415.13 | 17.50 | 10.50 | 7.50 |
Ratio of total debt to total capital | | 0.009 | 0.300 | 0.500 | 0.700 |
Bond rating | | AAA | AAA | AAA | AAA/AA |
The table shows that American Home Product’s profit margin is well above 10% at each of the proposed level, also the company’s interest coverage ratio is 17.5 times, 10.5 times and 7.5 times at 30% debt, 50% debt and 70% debt, respectively. Even at the 70% debt level, the company’s key ratios are better than Warner-Lambert Company’s; hence, we can assume that AHP will be able to maintain its bond rating.
Another way to access AHP’s financial risk is to look at the percentage EBIT can fall before the times interest earned drop to 1.0 at each of the proposed debt level.
Percentage EBIT can fall | | Actual | 30% Debt | 50% Debt | 70% Debt |
Times Interest earned | | 99.76% | 94.29% | 90.48% | 86.67% |
Even at the proposed 70% debt level, AHP’s EBIT can fall 86.67% before the times interest earned drop to 1.0. This indicates that AHP’s financial risk is relatively small compare to other pharmaceutical companies.
VL = VU +T x D
VL = EBIT x (1-T)/RE + T x D
Where V L is the leveraged company value, V U is the unleveraged company value, EBIT is the earnings before interest and taxes, T is the tax rate, and D is Debt.
| Actual | 30% | 50% | 70% |
RE | 18.33% | 18.33% | 18.33% | 18.33% |
EBIT | $ 922.20 | $ 922.20 | $ 922.20 | $ 922.20 |
T | 48% | 48% | 48% | 48% |
Debt | $ 13.90 | $ 376.10 | $ 626.80 | $ 877.60 |
VU | $ 2,626.73 | $ 2,626.73 | $ 2,626.73 | $ 2,626.73 |
Tax Shield* | | $ 173.10 | $ 292.91 | $ 412.76 |
VL | | $ 2,799.83 | $ 2,919.64 | $ 3,039.50 |
Earnings per Share | 3.18 | 3.33 | 3.41 | 3.49 |