Estimating LongTerm Funds Requirements and Sequential Financing

Case 6: AHP Corporation

1. 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 Exhibit 3? How
much potential value, if any, can American Home Products create for its shareholders at each of
the proposed levels of debt?

Ans. Business risk is the risk due to change of economic climate. So, it should be the unlevered
Beta that is calculated from the regression analysis of Market return and AHPs return. Thaat
unlevered beta is found 0.82, which means AHPs is less risky from market by 20%.

Financial risk is calculated from the equation: Beta (levered)=Beta(u)[1+(1-T)D/E] =0.82*[1+(1-

.48)*D/E]

1981(Actual) 30% D/E 50% 70%

Financial risk 1 1.25 1.82

The table shows AHP is becoming more risky with more debt financing.

Firms Value:

V(L)=V(U)+ T*B=[EBIT(1-T)/K]+ T*B

P=D1/k-g

K=1.9/30 +.12=18%
 Pro Forma 1981 for Varying Percentages of
Debt to Total Capital

30% 50% 70%

R0 0.18 0.18 0.18

EBIT 922.2 922.2 922.2

tc 0.48 0.48 0.48

D 376.1 626.8 877.6

VU 2,664.13 2,664.13 2,664.13
VL 2,844.66 2,965.00 3,085.38

Valued Added 1 8 0 .5 3 3 0 0 .8 6 4 2 1 .2 5
The same result graphic illustration..

The value added is value of so called tax-shield. The value of levered firm equals value of
unlevered firm plus value of tax shield. The more the debt in the capital structure, the higher will
be the value of a levered firm.

2. What capital structures would you recommend as appropriate for American Home Products?
What are the advantages of leveraging this company? The disadvantages? How would leveraging
up affect the companys taxes? How would the capital markets react to a decision by the
company to increase the use of debt in its capital structures?

Ans.

3.How might American Home Products implement a more aggressive capital

structure policy? What are the alternative methods for leveraging up?

4.In view of AHPs unique corporate culture, what arguments would you advance to persuade
Mr. Laport or his successor to adopt your recommendation?