Wednesday, April 2, 2008

Case: American Home Product Corporation

Date: February 2, 2006

Student Name: Pham Thi Thuy Ha Student ID: 2A5026

American Home Product Corporation (AHP), a highly growing American company, has four business lines: prescription drugs, packaged drugs, food products, housewares and household products. For a quite long time, AHP has applied a tight financial control and maintained an aggressive capital structure policy. Its mission is to make money for its stockholders and to maximize profits by minimizing costs. 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 ration and 49.71 collection days show that AHP can generate cash quickly, thus it can maintain current high growth rate. However, its 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 continue 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, the pro forma of different debt ratios show 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.

In contrast, 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 seems that the company can increase shareholders’ value by increasing debt ratios.

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. This solution does not bring financial risk to AHP but enable it to minimize business risk. If AHP only concerns about how to increase shareholders’ value and ignores market threats, it might lose its business to its competitors. In conclusion, AHP should change the financial policy to increase debt ratio at a certain level.

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