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Instruction for FIN6104 Case 2
Please read the case and answer the following questions to the best of your ability. As a team, you should submit one report for this case study. For the entire course, there will be three case studies in total and hence three report submissions. In the end of the semester, your team will deliver a presentation based on only one of the cases. (We will decide case allocations in due time.)
Case Information
Title: American Home Products Corporation
Source: Harvard Business School
Product #: 283065-PDF-ENG
Pages: 7
Link:https://store.hbr.org/product/american-home-products-corp/283065?from=quickSearch
Abstract: American Home Products is a company with virtually no debt. Students are asked to analyze the company's debt policy and make a recommendation to the CEO. It is likely that adding debt to the capital structure would create some value for shareholders; the CEO is firmly against borrowing.
Questions
Please keep in mind that there are often times multiple “correct” answers, depending on the assumptions you make. You need to justify your answers and assumptions. Please note that your report or presentation should not be structured in a simple manner to just answer these questions one by one. Instead, you should attempt to make a self-sufficient report (presentation) in the sense that a reader (audience)—who has not seen the case or this instruction—will be able to follow your report (presentation) seamlessly. For example, you will probably need a clear and concise introduction to help readers more quickly and better understand the goal of this report; you will probably want to make sure the paragraphs are logically linked. Furthermore, the scope of your project should not be limited by these questions; feel free to include additional discussions on other issues that you find interesting pertaining to the case.
1) What industry is this case focusing on? How come AHP has so little debt in its capital structure? Can you describe, just in words, some of the costs and benefits of AHP taking on debt and reducing its cash and outstanding equity?
2) The case presents pro-forma analysis in Exhibit 3 for different capital structures, along with the assumptions used to conduct this analysis in Exhibit 4. Does Assumption 6 make sense? Why or why not?
3) Does Assumption 2 make sense? Why or why not?
4) Please conduct new analysis to quantify the costs and benefits of taking on additional debt.
Step 1. Calculate the value of the firm in the base case scenario (using Actual 1981 figures from Exhibit 3). What is this value?
Step 2. Use the total debt levels calculated in Exhibit 3 for each potential capital structure scenario (30%, 50%, and 70% Debt-to-Capital). What would be the most likely rating of the debt in each case?
To assist you, please use the following table, which describes historical bond ratings and associated yields for the time period around 1981:
|
Bond ratings |
AAA |
AA |
A |
BBB |
BB |
B |
|
Bond yields |
14% |
14.4% |
15.1% |
16.5% |
17.1% |
18% |
|
Minimum ICR |
16.7 |
12.3 |
8.9 |
3.4 |
1.9 |
1.3 |
|
Default rate |
0.6% |
1.5% |
2.91% |
16.3% |
29.93% |
53.72% |
* ICR = interest coverage ratio
Note that for a bond to have a particular rating (and thus provide the yield indicated in the table), the firm must maintain an interest coverage ratio (defined by the ratio of EBIT to interest expense) that is above the minimum values provided in the table above. For each debt level, conjecture a bond rating and see if the associated interest coverage ratio is consistent with the values in the table; if the bond rating that you conjecture does not satisfy the interest coverage ratio requirements listed above, then conjecture a new (lower) bond rating, and iterate accordingly.
Step 3. Please calculate the present value of the debt tax shield in each scenario (assuming debt levels are constant and interest payments are perpetual).
Step 4. Please calculate the present value of expected distress costs. The probabilities of default associated with each credit rating are provided in the table above. Assume a loss of 20% of (base case) firm value in the case of distress.
Step 5. Compute the total value of the levered firmin each scenario. Based on this analysis, which capital structure scenario is best and why?
Report Submission & Presentation
You should submit the following files on Blackboard BEFORE November 24, 2024 (Sunday), 23:59. Please delegate the job of submitting to only one group member (i.e., each team should submit only once).
1) A PDF file that includes the body of your report and all necessary exhibits (such as tables or figures) to support the report. Your report should not exceed 3 pages (not including exhibits). The page limit is intended to force you to communicate succinctly and clearly; do not interpret it as suggesting that this project requires little work. The report should be clear, concise, but with sufficient detail such that it can be critiqued. You should include a cover page with your team number and all members names.
2) An Excel file that contains your models, detailed analysis, and other supporting data if any. Make the first worksheet (tab) of this file a cover page that includes your team number and all members names. The structure of this Excel file must be user friendly and please include necessary notes to explain what you have done.
Name the files using the following format such as “FM_Group_1.pdf” or “PT_Group_1.xlsx.”
Presentation
Your presentation will be 20 minutes. Please make sure it will not exceed 20 minutes. All group members must participate in the presentation and be prepared to answer questions (including but not restricted to questions about the business, industry, and your model).
Grade
The entire group project (3 reports + 1 presentation) will count 30% of your final grade.
For each report, a full mark of 5 points will be determined based on the overall quality of the report (including the main body, exhibits, and Excel models). For the presentation, 10 points will be determined based on the overall quality of your group’s performance. Lastly, we will have 5 points from peer evaluations to disincentivize free-riders: your contribution to this group project will be evaluated by each of your team members anonymously, on a basis of 5 points, and your peer evaluation score will be the average score.