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American Home Product Corporation (AHP), a highly growing American company, has four business lines: prescription drugs, packaged drugs, food products, house wares and household products. Its policies include:
-A tight financial control and maintained an aggressive capital structure policy. – Make money for its stockholders and to maximize profits by minimizing cost. – It has been able to finance internally its growth while paying a very high portion of its earning to its shareholders (60%).
Currently, AHP seems to have no business risk but may face a certain risk in the long run. Based on the ratios shown on the attached sheet, AHP should not worry about business risk since its working capital is very healthy ($1472.8 million) and cash excess $233 million. The high ROA, high profit margin, low current-to-asset ratio and 49.71 collection days show that AHP can generate cash quickly, thus it can maintain current high growth rate. However, it’s decreasing annual sales growth from 14.1% in 1978 to 8.8% in 1981 (exhibit 1) shows that it faces future risk of losing market shares in all its business lines if it does not foresee competition and continues to focus on increasing stockholders’ value.
AHP’s current financial performance is very good since it has high ROE (30.3), high quick ratio (42.68), low debt-to-equity ratio (0.09) and low debt-to-asset ratio (0.01). However, an analysis of different debt ratios shows that if AHP increases debt ratio, it will face a financial risk of increased debt-to-equity and debt-to-asset ratios. In other words, it will face solvency problems in long terms. AHP also face liquidity problems since the quick ratios decrease when the debt ratios increase.
2 The proposed mechanism follows a dual mechanism of leveraging:-
(a) Increase the Debt Equity Ratio.
(b) Buy back the shares. This also results in the following:-
(i) Improves EPS as the amount gets shared by lesser number of shares.
(ii)Improves Price / earnings ratio
(iii) The excess capital gets utilized.
(iv)Sends a +ve signal to the market and share prices likely to increase.
(v) Improves Return on Equity ratio.
The calculations enclosed indicate that the best option in accordance with the company stated policy would be to have Debt-Equity Ratio of 70%. Shareholders’ value increases when debt ratios increase. EPS increases from $3.18 to $3.49. The dividend payout ratio also increases from 0.597 to 0.602. Similarly, the dividend yield from 0.063 to 0.070. It means that the company can increase shareholders’ value by increasing debt ratios.
However the following needs to be considered:-
(i) The valued net worth of the firm which decreases may not convey the correct picture to the investor and thus negating the positive signals of buy back of shares. (ii) The firm has no strategy related to R&D in new products and focuses on me-too products thus constituting a large business risk. (iii) The firm would reduce the cash to debt ratio substantially exposing itself to financial risk. The closest competitor has Debt – Equity Ratio of 30% which if taken as a benchmark gives a conservative method of deciding the proposed leveraging, however this does not maximize the shareholder value, but is in line with the strong conservatism philosophy of the firm. It also gives a better Return on Assets ratio and has a safer Debt to Cash ratio.
Even though AHP has a very good current financial performance, it should change the financial policy to increase debt ratio at a certain level. To meet the goal of increasing shareholders’ value, AHP should not use its excess cash flow to repurchase its stocks because this is only a temporary solution and may generate serious financial problems in the long run. Instead, AHP should use this excess cash to invest in profitable projects to improve its current products and launch new products that meet current market demands. By doing so, AHP can minimize the business risk, prepare itself for competition and increase sales growth.
On the other hands, AHP should increase debt ratio to a certain level that is suitable for its business to increase shareholders’ value. Also it should continue to exercise tight monetary policies as earlier to pay off the debt in a disciplined manner This solution does not bring financial risk to AHP but enable it to minimize business risk. If AHP remains only concerned about how to increase shareholders’ value and ignores market threats, it might lose its business to its competitors.