. 3. What capital structure would you recommend as appropriate for AHP?

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 structure? Ans: Most appropriate capital structure for American Home Products is 30% debt to total capital. Advantages of using above mentioned capital structure:(1) Using 30% debt ratio, the company would be able to be recapitalized; hence, common shares outstanding of 19.8 million can be repurchased.

Table 4 illustrates 1981 results for alternative capital structure Actual 1981 455.2 Pro Forma 1981 for 30% Debt to 50% Debt to Total Capital Total Capital 417.4 400.5 37.8 54.7 70% Debt to Total Capital 383.7 71.5

Taxes Taxes Savings

(2) According to Table 4, AHP would have advantage to save taxes of 37.8 million dollars and its shareholders benefit by getting more values. Exhibit 2 shows that Warner Lambert Companys debt ratio is approximately 32% and its bond rating is AAA or AA. It means that if AHP uses 30% debt and 70% equity, its bond rating will be same as Warner Lambert; consequently, bond interest to pay will not increase much due to bond rating. (3) AHP would face less risk to compare heavier capital structures. (4) AHPs annual growth in sales decreased in 1981 by 2.9% from previous year, so getting debt could be helpful to manage its operation effectively and increase its sales growth.

Disadvantages of using above mentioned capital structure:(1)If a firm has a loan, it has to be responsible to pay its principle and interest as a schedule; otherwise, it would be reason to bankruptcy; thus, same rule works on case of AHP. (2)If the companys daily operation requires more investment after recapitalization, getting new loan for it would be more difficult. In final, using debt can be reason to increase its financial risk, so it has to be more careful to manage its operation. (3)According to Table 4, leveraging the company by using 30% debt to capital structure would decrease its taxes of 37.8 million dollars to pay. (4)The capital market would react positively to a decision by the company to use of 30% debt in its capital structure. The company had almost no debt and had excess of cash or higher liquidity and Mr. Laborte who was chief executive of the company was near to give his position because of retirement, so most analysts expected the company to change its conservative capital structure. (5) Table 5 shows the market positive reaction on the stock price. Table 5 Stock Price of AHP ($ in millions except per share data and ratios) Pro Forma 1981 for Actual 1981 497.3 155.5 3.2 1.9 10.6% 30.0 30% Debt to Total Capital 452.1 135.7 3.3 2.0 9.5% 31.5

Profit After Tax Average Common Shares Outstanding (millions) Earnings Per Share Dividend Per Share Price/Earnings ratio Common Stock Price

According to Table 5, AHPs stock price will increase to 31.5. In order to calculate new stock price, we used average price/earnings ratio of both American Home Products Corporation

and Warner Lambert Company in Exhibit 2 because exhibit 2 illustrates that while P/E ratio of AHP is 10.6%, 8% for Warner Lambert and unlike Warner Lambert, AHP has less financial risk. All though AHPs risk will increase after getting leverage and its P/E ratio will decrease, AHP would have better financial position than Warner Lambert, so investors would be interested to buy AHPs stock rather than stock of Warner Lambert.

4. How might AHP implement a more aggressive capital structure policy? What are the alternative methods for leveraging up? Ans: AHP should use heavier capital structure which means that increase to use more debt instead of conservative capital structure; consequently, AHPs capital structure might be more effective and aggressive. The alternative methods for leveraging up are:(a) Innovating new products (b) Using better technology (c) Motivating labor.

5. In view of AHPs unique corporate culture, what arguments would you advance to persuade Mr. Laporte or his successor to adopt your recommendation? Ans: According to Mr. Laporte, his company works in order to increase shareholders wealth, so as using 30% debt to capital would give possibility to save 37.8 million dollars from taxes; thus, its shareholders would benefit getting higher dividends per share. Even though after using debt, its price/earnings ratio might be decreased, its attraction of investors will be still powerful because of stock price increase. Also, if the company uses more debt to the operation, it will be possible to repurchase common stocks of 19.8 millions of shares from market.