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.