The following report analyses the debt policy and capital structure of AHP.

1) The combined effect of operating risk and advantage risk is Business Risk. Higher
the debt higher is the financial risk of the company because of increased interest costs.
American Home Products’ cash was about 23% of total assets, it steadily rose from
1978 to 1981, and then 28.2% in 1981; thus, it has sufficient liquidity to run its day-to-
day operations. The return on assets can show that a firm’s ability to cover its operating
cost by generating income. American Home Products Corporation’s ROA was stable,
19.2 % in 1981; consequently, AHP earned enough income to cover its operating cost
The value created by debt is the tax shield it provides. With an increased level of debt,
AHP’s primary business strategy of plowing back retained earnings will not be taken
care. According to Exhibit 4, American Home Products used excess cash of 233 million
dollars on each of the proposed levels to repurchase stocks, and remaining amounts
were financed by debt; thus, its common shares outstanding would decrease by 19.8
million shares on 30% debt ratio and 36.6 million shares on 70% debt ratio. It means
that equity will go down, so its return on investment will rise. AHP should consider
the financial risk to change the capital structure. American Home Products
Corporation could try to save taxes by increasing debt. For instance, the company’s
capital structure is 70% debt to capital, compared to 30 % debt to complete capital
structure, it can save approximately 190% times more significant money; thus, its
shareholders would benefit from it.

2) We would recommend a D/E ratio of 30% for AHP. The advantages of leveraging
the company are its tax-deductibility and the fixed rate of return the investors get, as
the company is doing well, it can reduce its cost of capital. The disadvantages are after
a certain point of debt, interest costs are enormous and reduce the tax benefits. Also
during period of low sales, interest costs are fixed, and higher fixed costs can lead to
bankruptcy. Leveraging up will decrease the company taxes by the amount of $37.8m.
Increased debt up to 30% will reduce the cost of capital after that high leverage can be
seen as a potential risk and stock market will respond positively. The repurchase of
shares will reduce the equity and ROE will increase. Higher cash flows will increase
the share price up to 31.5.
3) AHP should use a more substantial capital structure, which means it would use
more debt instead of a conservative capital structure; consequently, AHP’s capital
structure might be more productive and competent. The other methods for benefiting
are innovating new products, using better technology, and motivated labor.

4) As said by Mr. Laporte, the company works in order to increase shareholders'

wealth, so using 30% debt to capital would help to save 37.8 million dollars from taxes;
thus, its shareholders would benefit from getting higher dividends per share. Even
though after using debt, its price/earnings ratio might be decreased, its attraction of
investors will be still compelling because of the stock price increase. In addition, if the
company uses higher debt to the operation, it will be possible to repurchase common
stocks of 19.8 million shares from market.

Calculations:

The following exhibit shows the proportion of cash and total assets, 1976-1981 ($ in millions)

1981 1980 1979 1978 1977 1976

Cash 729.1 593.1 493.8 436.6 322.9 358.8
Total 2588.5 2370.3 2090.7 1862.2 1611.3 1510.9
Assets
Proportion 28.2% 25.0% 23.6% 23.4% 20.0% 23.7%

The following exhibit Ex 3 Pro Forma 1981 Results for Alternative Capital Structures (in
millions)

Actual 1981 for 30% Debt 50% Debt To 70% Debt To

To Total Total Capital Total Capital
Capital
Total Debt 13.9 376.1 626.8 877.6
Net Worth 1472.8 877.6 626.9 376.1
Required 1486.7 1253.7 1253.7 1253.7
Capital
Interest Rate 14.0% 14.0% 14.0% 14.0%
Tax rate 48.0% 48.0% 48.0% 48.0%
EBIT 954.8 922.2 922.2 922.2
PAT 497.3 452.1 433.9 415.6
NOPAT 496.5 479.5 479.5 479.5
ROIC 33.4% 38.3% 38.3% 38.3%
ROE 33.8% 51.5% 69.2% 110.5%
Average Shares 155.5 135.7
O/S
Stock Price 30.0 31.5