American Home Products Corp.
How much financial risk would American Home Products face at each of the proposed debt levels shown in case Exhibit 3? What debt rating would American Home received at each of the proposed debt levels?
Comparison Table $ in million USD | American Home Products Corp. | Warner. Lambert Company | | Actual | Pro Forma 1981 for | Actual | | 1981 | 30% Debt to Total Capital | 50% Debt to Total Capital | 70% Debt to Total Capital | 1980 | Net Worth | $1,472.8 | $877.6 | $626.9 | $376.1 | $1,482.7 | Earnings per Share5-year CAGR | $3.1812.4% | $3.3312.4% | $3.4112.4% | $3.4912.4% | $2.413.0% | Return on Equity | 33.8% | 51.5% | 63.9% | 110.5% | 13.0% | Interest Coverage | 415.13 x | 17.5 x | 10.5 x
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1) It is obvious that when take on more debt, the risk of ability to service the interest payment is increased. However, in case of AHP they still have a certain level to absorb more debt into their balance sheet. Even at 70% Debt to Total Capital ratio, their interest coverage still better their competitor. 2) The higher ratio of Debt to Total Equity may result to the lower of the debt credit rating. The lower of the credit rating will result to increase of the interest rate which will cost more to the company. 3) The interest resulting from the debt also will cost to the company even it is taxable. The interest is fixed base on the level of the debt even the company does not generate profit. This would need to be careful when take on the debt comparing to use its own capital. And the creditor may come to intervene on the business when the company has difficulty to service its debt.
With different level of the debt of the company according to Exhibit 3, we would predict by comparing to its peer Warner. Lambert Company at 32.4% debt to total capital ratio still maintain at weak AAA level. AHP had much better financial performance e.g. Earnings per Share and Return on Equity. With 50% Debt to Total Equity ratio, AHP may receive lower rating at AA level and we do not expect them to go lower than BBB rating even with 70% Debt to Total Equity
Heitor Almeida, T. P. (2004, 10 1). How should we discount the costs of financial
CML's equity ratio increased to 0.4 and correspondingly debt ratio decreased to 0.15 from 2001 to 2005. Generally it is a good trend, even though there has been a decrease in equity ratio in 2005 from 0.45 to 0.40 and an increase in debt ratio from 2004 to 2005, it may be due to the acquisition from US group KKR. However, in 2005, equity is almost three times debt, which means the capital structure is still in good condition.
MCI would be better to keep its capital structure of 55% debt. The cost of equity is high because raising more equity will dilute the value for existing shareholders. Due to the fact that MCI has a high leverage, it is not feasible to issue debt. Additionally, MCI has exhausted the line of credit from the banks and used convertible debentures frequently. MCI belongs to a competitive and regulatory industry. The high leverage will limit its potential to grow. In exhibit 8, MCI does not have a bond rating. The convertible bond allowed the company to raise capital and convert to equity later. The interest coverage ratio of AT&T is 3.6X whereas that of MCI is 4.2X. After increasing the market share, the company can obtain a bond rating by decreasing its financial leverage.
If HCA chooses to remain at the current debt ratio take on a lower rating, suspicion might arise among investors. In both cases opportunities exist as well as consequences. The advantages and disadvantages are outlined in Scenario 1 - 3.
An analysis of a repurchase of stock for $400 million cash, and recapitalization to 80% debt-to-total capital by borrowing $1.27 million reveals that BBBYs return on equity will be 113%, return on assets 61% and an after tax cost of debt of 28%. ROE is > ROA and ROA > after tax cost of debt. With the 80% debt-to-total capital structure ROE exceeds the other two capital structure scenarios of no debt and 40% debt-to-total capital. While all of this looks great there are other considerations. The household and personal products industries debt to total asset ratio is 34.69% while BBBY debt to total asset ratio is at 44% ($1,270,000/$2,865,023). Increasing to this capital structure would also reduce shareholders earnings per share.
* Current ratio of 3.53 shows that Adidaz is in a healthy situation and has the ability to pay off future debt. (Increase of 0.45).
Based upon the firm’s low target leverage of 5%, low degree of operating leverage, and favorable credit history and financial outlook, the model assumes a cost of debt in line with AAA corporate debt at 7.02%. This estimate seems reasonable and sensitivity analysis shows a 1% decrease in the forecasted share price requires at least a 2.4% increase in the cost of debt.
Managing debt levels to maintain an investment grade credit rating as well as operate with an efficient capital structure for its growth plans and industry
Target Corporation is having a very stable financial policy and dividend policy. From the historical financial data, Target had debt $11,044M, $11,202M, $10,599M, $17,471M, and $19,882M in the year of 2005,2006,2007,2008, and 2009 respectively. The long-term debt/equity ratio rises from 69.34% to 108%.
The effect of financial leverage on the cost of equity is prevalent in the Modigliani-Miller capital structure theory. Since the financial leverage increases the cost of equity, it can be considered one of the disadvantages of borrowing. As shown in Appendix A, the cost of equity, at each debt to capital ratio, increases by 0.1% as the financial leverage increases by 10%. With a higher
As always with advantages, disadvantages are present to. They include: an increase in financial risk. Despite the tax shield, the interest payment will result in a decrease to net income, and the bond rating could decrease to a AA status. The bond rating for a AAA is determined by a 18 Times Interest Earned Ratio. Once AMH increases their leverage to 30%, they will decrease their TIE to 17.50. Whereas, a AA is currently rated around a 9, further debt acquisition could result in a decrease of their bond rating and a decrease in value for stockholders. (Calculation: EBIT/Interest= tie ratio 922.2/52.,7=17.50)
The debt-to-capital ratio gives users an idea of a company's financial structure, or how it is financing its operations, along with some insight into its financial strength. The higher the debt-to-capital ratio, the more debt the company has compared to its equity. Star River has always depended much on debt for its financing and the trend shows this ratio may get higher in future. Star River, with high debt-to-capital ratios, compared to a general or industry average, may show weak financial strength because the cost of these debts may weigh on the company and
In terms of financial flexibility, a relatively high interest coverage ratio (ICR) of 36.8 supports the company’s ability to Flexibility take on more debt. Especially by comparing the ratio with its peers, such ratio seems to match with its risk aversion philosophy. Agency Cost of Debt
The long-term liquidity risk ratio such as LT debt/Equity, D/E, and Total Liabilities to Total Assets all show a decline from year 2005 due to the repayment of debts. The interest coverage ratio also shows a healthy number of 29.45 in comparison to the industrial average of 15.04 indicating a high ability to pay out its interest expense. Such a low relative risk is not surprising due to the nature of its business depending heavily in R&D development and large intangible assets.
The core problem for Allen Distribution Company is how to distinguish from the marginal accounts the difference between good creditors and bad creditors. Especially we show how the difference between creditors can be utilized in practice by the credit representatives. For this we provide clear guidelines. The option of extending the Morse Photo Company’s $ 1000 credit line is used as test case for these purposes.