American Home Products Corp. Case Analysis
American Home Product (AHP) was founded in 1926 with the merging of several small home product companies. As the company expanded in the 1930’s, it acquired companies in different businesses. After World War II, the company had four lines of businesses: prescription drugs, packaged (over-the-counter) drugs, food products, and housewares and household products. Although the name “American Home Product” has never appeared on its products, the firm produces many well-known brands in the market, such as Anacin, Woolite and Chef Boyardee.
Starting from the 1960’s, the firm caught a lot of attention with its almost debt-free capital structure. Its chief executive, William F. Laporte, enforced on top-down management system and …show more content…
The first step to compute the present value of the interest tax shield is the determination of the interest expense of the 3 restructuring options. This is the interest rate (14%) times the particular debt amount in each situation. For the purpose of getting the interest tax shield, we multiply the tax rate (48%) with each of the interest expenses. These tax benefits reflect the savings in taxes resulting from interest payments to debt holders that reduce the EBT.
Afterwards, the present value of the interest tax shield of permanent debt can be calculated in two different ways.
Firstly, it can be determined with the following formula: PV(Interest Tax Shield) = T*D
Under the second method, we have to consider the definition of the present value of the interest tax shield. Taking into account the fact that the debt issued is perpetual, we review that the present value of a perpetuity can be calculated by dividing the amount of cash flows (in this case: interest expense) by its interest rate (PV = CF/i).
Using one of the previous approaches, the present value of the tax benefits ranges from $25.27 (30% debt) to $58.97 (70% debt).
We recognize that the tax benefits increase with adding debt. This phenomenon can be derived from the fact that interest expenses increase with additional debt. Assuming the same interest rate, the logical conclusion is that the present value of the interest tax shield goes up if the amount of debt increases.
b. What is the change in