Introduction
The assignment pertains to analysis of American Home Products Corporation to analyse the financial strength of the company coupled with forecasting of the financials. American Home Product Corporation deals in prescription drugs, packaged drugs, food products and housewares and household products. The company has a very strong hold in the market with the 1981 revenue of $4 Billion with over 1500 brands in the kitty of the company. The company has a distinctive corporate culture with a string control over financials. All the expenditure of the company over $ 500 required prior approval of the by the chief executive, Mr. William Laporte. The company is quite averse and conservative in its approach towards adoption of new products and brands. Even with such drawbacks, the corporate has achieved a strong, stable and consistent growth. Further, the company has been debt free for a very long time and is now exploring the possibility of aggressive capital policy.
Analysis of operative Strategy of AHP
AHP operative strategy is quite conservative. The company has been quite risk averse with consistent avoidance of risk of developing a new product in the market as the market of drug manufacturing is highly volatile. The company has majorly manufactured products which have been previously developed by other firm and company has acquired or licensed the manufacturing of same. Further, the large base of 1500 brands are not invention rather represent clever extension of the existing product. The company has a strong marketing team with little or no R& D and invention. Also, the company operating strategy revolves around the decision of the Chief Executive Mr. William Laporte who has been defined as Brilliant Marketer and tightfisted spender. Thus, in one line the company operating policy may be defined as very cautious investor who does not want to take any risk and earns stable returns.
Analysis of Financials of the Company
The following ratios may be used to analyse the financials of the company:
- Net Sales Margin;
- Return on Asset;
- Return on Equity;
- Days Receivable Ratio;
- Days Inventory Ratio;
- Days Payable Ratio;
- Current Ratio;
- Quick Ratio;
- Debt/ Equity Ratio;
- Debt/ Total Asset ratio;
- Leverage;
- Times interest earned.
Ratio analysis is critical for understanding and analysing the financial performance of the company. The analysis helps to understand the company’s solvency, soundness and performance of the company in comparison to others. The ratios have been classified under four categories roughly Profitability ratios encompassing net sales margin, return on asset and return on equity. Activity rations encompassing Days Receivable Ratio, Days Payable Ratio and Days Inventory Ratio. Liquidity ratio encompassing current ration and liquid ratio and debt ratio encompassing the rest. The analysis has been made for past two years:
Profitability Ratios:
The profitability ratios helps to understand the financial performance of the company. These ratios helps to understand the operating performance and helps to understand whether the company has been able to generate return based on investment made. The analysis of ratios have been presented as under:
Net Profit Margin: The said ratio is computed using Net profit Margin and Sales of the company. The ratio indicates the margin earned by the company by making 1$ sale. The higher the margin, the better the profitability of the company. The computation of margin by using the formula presented here-in-below:
Return on Asset: The said ratio is computed using Net profit Margin and Total Asset of the company. The ratio indicates the margin earned by the company by utilising 1$ Asset. The higher the margin, the better the profitability of the company. The computation of margin by using the formula presented here-in-below:
Return on Asset: Net Profit/ Total Asset
Return on Equity: Computed similarly
The computation of profitability ratios for the past two years is presented as under:
| Profitability Ratios | 1981 | 1980 |
| Net sales Margin | 12.04% | 11.74% |
| Return on Asset | 19.21% | 18.81% |
| Return on Equity | 30.1% | 30.3% |
Activity Ratios
These ratios helps the company to measure its ability to convert different accounts within its balance sheet into cash. This ratios helps to measure the efficiency of the company and activity cycle of the company encompassing payables, receivable and stock. Since, no data is present the three ratios have not been computed.
Liquidity Ratios
These ratios help to understand the financial solvency of the company. These ratio measure the ability of the company to meet any short term obligations and the financial soundness of the company. These ratios are determined by using the current asset and current liability of the organisation. Since, no data is present the two ratios have not been computed.
Debt Ratios
Debt Ratios are used as one of the effective financial tool to understand the degree of leverage of the company. These ratios helps to analyse the portion of capital structure of the company which is financed by debt and the portion of the capital by owner’s capital. The company has very low level of debt. Some of the debt ratios computed has been presented here-in-below:
Debt/ Equity Ratio: These ratio measure the level of debt of the company in comparison to the equity. The highest debt level generally allowed is in ratio of 2:1. Further, these ratio represents the percentage of debt in compared to equity. If the debt is high, it represents the benefit of trading on equity. The formula used for computation is presented as under:
Debt/ Equity Ratio: Debt/Equity
Debt/ Asset Ratio: Computed similarly as above
The computation of profitability ratios for the past two years is presented as under:
| Debt Ratios | 1981 | 1980 |
| Debt / Equity Ratio | 1.00% | 0.94% |
| Debt / Asset Ratio | 0.64% | 0.59% |
Based on above analysis, it may be inferred that company has very strong financials and loan availing shall not be an issue for the company considering the current debt level and profitability of the company.
Debt Structure Recommendation
Considering the representation of Earning per share under different debt structure/ capital structure, it shall be ideal on the part of the company to opt for 30% debt structure as currently the market of the sector dealt in is mostly unleveraged and the highest leverages used is 32% by Warner Lambert. Thus, company should not become too extra aggressive and hold its stand of being a follower while opting for capital policy. Also, the benefit of trading on equity is evident from the increasing returns to shareholders.
Tax benefit associated with Debt
Generally, the payment of interest on debt is allowed as indirect expenses in profit and loss account. Thus, the said expense are allowed as deduction for the purpose of computation of net profit. Accordingly, the expenditure on debt provides a tax shelter to the company at the rate of prevailing corporate tax rate. While on the other hand dividend payment does not provide any tax shelter to shareholders and it is a below the line item.
Change in AHP financial policy
AHP financial policy shall be changes considering the change in trend of the market and the benefits associated by changing the debt structure. The success of comparable companies which have increased the benefit to its shareholders by opting for a debt laden capital structure in the form of trading on equity shall serve as an ideal convincing element to the management. Also, the pro-forma calculation of EPS growth and dividend shall also convince the management of the benefit of debt in the capitals structure. Further, under the concerned scenario WACC has been computed at 14.64%.
The structure of 30% debt shall help the company by bounds and leap to increase the wealth of shareholders of the company. Also, the said structure shall help the shareholders gain back certain portion of their wealth as company shall use the proceeds of debt instrument to purchase the equity share from the market at the rate of 30 per share as given in the concerned case. Further, the company shall also be profited from the fact that debt instruments are tax deductible and according corporate tax rate of 48% shall be saved on the amount of interest paid by the company every year. In addition to above, the above structure shall also reduce the Weighted Average Cost of Capital and company can execute new projects at a reduced cost.
Pro-forma next year
The pro-forma next year has been computed by taking the average growth rate for the past 5 years has been taken the average growth rate. Based on such growth rate, computation of growth in revenue and cost shall be taken to be grown by the growth rate.
Post above, the EBIT has been computed by taking the said growth rate and interest has been kept constant. Further, post above, tax rate has been applied at the rate of 48% to obtain profit after tax. Also, dividend payout ratio has been considered @60%. Based on the said analysis the pro forma computation has been enclosed in the excel.
Further, under the concerned scenario WACC has been computed at 14.64%.
Pro-forma Computation
