American Home Products Corporation: Study Case

FIN6252 - Financial Planning & Strategy
Study Case
American Home Products

Corporation
Capital
Capital Structure
Structure
Distinctive
Distinctive Corporate
Corporate Policy
Policy
Culture
Culture
frugality
frugality
tight
tight financial
financial
CASE
reticence
reticence
control
control
INTRODUCTION
financial
financial
conservatism
conservatism
Impressive
Impressive Recapitalization
Recapitalization
Performance
Performance Results
Results Plan
Plan

Description
 American Home Products (AHP), is one of the largest pharmaceutical companies
in the world
 AHP’s 1981 sales of more than $4 billion were produced by over 1,500 marketed
brands
Four Lines of Business
Houseware & Home

Prescription Drugs Packaged Drugs Food Products
Products

Consumer Products
Well-known
Brand
Names

“THEY SELL THE HELL
OUT OF EVERYTHING
THEY’VE GOT”
AHP’s Chief Executive
“I just don’t like to owe

money…”
A E B
 At the end of 1980, AHP had almost no debt and a cash balance equal to 40% of
its net worth

AHP’s Distinctive Culture
emanated from its chief

executive…
FRUGALITY
FRUGALITY
CONSERVATISM
CONSERVATISM CENTRALIZING
CENTRALIZING
&
&
RETICENCE
RETICENCE &
& COMPLETE
COMPLETE
TIGHT
TIGHT FINANCIAL
FINANCIAL
RISK
RISK AVERSION
AVERSION AUTHORITY
AUTHORITY
CONTROL
CONTROL
DISTINCTIVE CORPORATE CULTURE

Reticence
A poll of Wall Street
analysts ranked AHP last
in corporate
communicability among
21 drug companies
Wall Street Analysts’ Ranking:
… 1
… …
American Home Products 21

Frugality and Tight Financial Control
 All expenditures greater than $500 had to be personally approved by Mr.
Laporte… even if authorized in the corporate budget

Conservatism and Risk Aversion
 AHP consistently avoided much of the risk of
new product development and introduction in
the volatile drug industry
 Most of its new products were acquired or

licensed after their development by other firms
or were copies of new products introduced by
competitors
 AHP thus avoided risky gambles of R&D and new

product introductions… and used its marketing
prowess to promote acquired products and
product extensions

Centralyzing Complete Authority

AHP’s Performance
 Stable, consistent growth and profitability… increased sales, earnings, and
dividends for 29 consecutive years through 1981
>>> In millions of dollars except per share data Exhibit 1.

Business
Business Risk
Risk
Hamada’s
Hamada’s Equation
Equation
WACC
WACC
Cost
Cost of
of Equity
Equity
Capital Financial
Financial risk
risk
Capital Structure
Structure
leverage
leverage
QUESTION 1.
Value
Value to
to beta
beta
Shareholders
Shareholders
Proposed
Proposed Capital
Capital
Cost
Cost of
of Debt
Debt Structures
Structures

QUESTION 1.
 How much business risk does American Home Products face?
 How much financial risk would American Home Products face at each of the
proposed levels of debt shown in case Exhibit 3?
 How much potential value, if any, can American Home Products create for
its shareholders at each of the proposed levels of debt?

Hamada’s Equation
 Is used to separate the financial risk of a levered firm from its business risk
 It is used to help determine the levered beta and, through this, the optimal
capital structure of corporate firms
Business
Financial Risk
Risk (β
(βUL)

Business Risk
.
Rc
RM

Data Source
.

Data Source (Cont)
.

Regression Analysis
.
β = 0.82

Per sake of study…
.AHP CO
S&P 500
0.58 -0.46 0.64 1.69 1.04 1.23 1.62 0.68 0.41 0.09 1.32

QUESTION 1.

Financial Risk
Financial
Risk
Business … how much risk

Risk leverage adds to the
risk of business…

Financial Risk Cont.
Pro Forma 1981 for Varying

Actual Percentages of Debt to Total Capital
1981
30% 50% 70%
T 47.79% 48% 48% 48%
D/E 0.43 1.00 2.33
βU (business risk) 0.82 0.82 0.82 0.82
βL (financial risk) 1.00 1.25 1.82

QUESTION 1.

Firm Value
CHANGES THE VALUE

IN CAP STRUCTURE OF THE FIRM
IF and only IF
BENEFIT (THE PIE)
SHAREHOLDERS INCREASES

Firm Value
Cost of equity of PV of
unlevered firm interest tax-shield
Dividend
Dividend Discount
Discount Model
Model

Firm Value Under Each Structure
Pro Forma 1981 for Varying Percentages of

Debt to Total Capital

30% 50% 70%
R0 0.18 0.18 0.18
EBIT 922.2 922.2 922.2
tc 0.48 0.48 0.48
D 376.1 626.8 877.6
VU 2,664.13 2,664.13 2,664.13
VL 2,844.66 2,965.00 3,085.38
Valued Added 180.53 300.86 421.25

Graphic Illustration
70% Debt
50% Debt
30% Debt
Debt Free

BACK TO SHAREHOLDERS
Under the Current Structure
ROE
EPS Common shares outstanding 155.5
Taxes 47.77%
Debt 13.9
Equity 1472.8
Recession Expected Expansion

EBIT 300.0 922.2 1300.0
Interest -2.3 -2.3 -2.3
Profit before taxes 297.7 919.9 1297.7
Taxes -142.2 -439.4 -619.9
Net Income 155.5 480.5 677.8
Dividends on preferred stock -0.4 -0.4 -0.4
Earnings available to common shareholders 155.1 480.1 677.4
EPS $1.00 $3.09 $4.36
ROE 10.56% 32.62% 46.02%

30% Debt
ROE
Taxes 48%
Debt 376.1
Equity 877.6

EBIT 300.0 922.2 1300.0
Interest -52.7 -52.7 -52.7
Taxes -118.7 -417.4 -598.7
Net Income 128.6 452.2 648.6
EPS 6% $0.94 7.8% $3.33 9.6% $4.78
ROE 14.66% 51.52% 73.91%

50% Debt
ROE
Taxes 48%
Debt 626.8
Equity 626.9

EBIT 300.0 922.2 1300.0
Interest -87.8 -87.8 -87.8
Taxes -101.9 -400.5 -581.9
Net Income 110.4 433.9 630.4
EPS 14% $0.86 10.4% $3.41 13.5% $4.95
ROE 17.61% 69.22% 100.55%

70% Debt
ROE
Taxes 48%
Debt 877.6
Equity 376.1

EBIT 300.0 922.2 1300.0
Interest -122.9 -122.9 -122.9
Taxes -85.0 -383.7 -565.0
Net Income 92.1 415.7 612.1
EPS 23% $0.77 13% $3.49 18% $5.14
ROE 24.49% 110.52% 162.75%

Summary
 Under the expected and expansion EPS ($/Share)
scenario leverage increases the returns Recession Expected Expansion
Almost debt-free 1.00 3.09 4.36
to shareholders as measured both by
30% D 0.94 3.33 4.78
ROE and EPS
50% D 0.86 3.41 4.95
70% D 0.77 3.49 5.14
 However, ROE and EPS much more
sensitive to changes in EBIT under
financial leverage: as debt increases EQUITY
from 30% to 70% volatility of ROE and
EPS also increases
 With the increase of leverage DEBT

shareholders have a potential to receive
ROE (%)
more value… however at the cost of
higher risk
Almost debt-free 10.56 32.62 46.02
30% D 14.66 51.52 73.91
50% D 17.61 69.22 100.55
70% D 24.49 110.52 162.75

QUESTION 1.
 How much business risk does AHP face?

Debts
Debts and
and Equity
Equity
Leverage
Leverage
Optimal
Optimal Capital
Capital
Structure
Structure
Recapitalization
Recapitalization
Financial
Financial distress
distress
QUESTION 2.
Rating
Rating
Capital
Capital Market
Market
Reaction
Reaction
Credit
Credit Spread
Spread
Break
Break even
even EBIT
EBIT

QUESTION 2.
 What capital structure would you recommend as appropriate for American
Home Products?
 What are the advantages of leveraging this company?
 The disadvantages?
 How would the leveraging up affect the company’s taxes?
 How would the capital markets react to a decision by the company to

increase the use of debt in its capital structure?

Capital Structure Under 3 Special Cases
CASE I CASE II CASE III
Assumptions: Assumptions: Assumptions:

•No corporate taxes •Corporate taxes •Corporate taxes
•No bankruptcy costs •No bankruptcy costs •Bankruptcy costs
Proposition I: Proposition I: • As the D/E ratio increases, the

•The value of the firm is not •The value of the firm increases probability of bankruptcy increases
affected by changes in the capital by the present value of the annual • At some point, the additional
structure interest tax shield value of the interest tax shield will be
Proposition II: Proposition II: offset by the increase in expected
•The WACC of firm is NOT •The WACC decreases as D/E bankruptcy cost
affected by capital structure increases because of the • At this point, the value of the firm
government subsidy on the interest will start to decrease and the WACC
payments will start to increase as more debt is
added
Equations: Equations:
•WACC = RA = (E/V)RE + (D/V)RD •RA = (E/V)RE+(D/V)(RD)(1-TC)
•RE = RA + (RA – RD)(D/E) •RE = RU + (RU-RD)(D/E)(1-TC)

Capital Structure Under 3 Special Cases
CASE I CASE II CASE III
Assumptions: Assumptions: Assumptions:

•No corporate taxes •Corporate taxes •Corporate taxes
•No bankruptcy costs •No bankruptcy costs •Bankruptcy costs
CONCLUSIONS: CONCLUSIONS: CONCLUSIONS:

•No optimal capital structure •Optimal capital structure is •Optimal capital structure is part
almost 100% debt debt part equity
•Each additional dollar in debt •Occurs where the benefit from
increases the cash flow of the firm an additional dollar of debt is just
offset by the increase in expected
bankruptcy costs

In Accordance with the Case II
30% 50% 70% RE
D/E 0.43 1.00 2.33

RD
TC 48.00% 48.00% 48.00%
RD 14.00% 14.00% 14.00% WACC
RU 18.00% 18.00% 18.00%
RE 18.89% 20.08% 22.85% RD (1-TC)

WACC 15.41% 13.68% 11.95%

Breakeven EBIT Analysis
Debt 70%
Almost debt-
free
EBIT = 400.00 EBIT = 920.00

BUT THIS IS
INCONSISTENT WITH
THE REAL WORLD…
IS 100% DEBT A SOLUTION?

FIRMS GENERALLY
EMPLOY MODERATE
AMOUNT OF DEBT…
AND
THE REASON IS….
THERE IS A COST OF
FINANCIAL
DISTRESS
Case III is More Realistic
 In the presence of:
>>> Corporate taxes
>>> Bankruptcy costs
 Equations for WACC and RE are still the same…
 But now we need mechanism to incorporate risk of

financial distress

Rating Mechanism
D/E Rating Credit Spread
0.00 AAA 0.20%
0.41 AA 0.50%
0.63 A 1.00%
1.60 BBB 1.50%
2.50 BB 2.00%
4.17 B 3.25%
6.67 CCC 5.00%
9.95 CC 6.00%
14.28 C 7.50%
RD = RF + Credit Spread

Risk of Financial Distress
Credit RF = 13.16%
D/E Rating
Spread Credit Spread + RF
0.00 AAA 0.20%
0.41 AA 0.50%
0.63 A 1.00% D E D Credit Spread Interest Cost of Debt Cost of Equity WACC
(D+E) (D+E) E % % % % %
1.60 BBB 1.50%
0.10 0.90 0.11 0.29 13.45 6.99 18 16.63
2.50 BB 2.00% 0.15 0.85 0.18 0.33 13.49 7.01 18 16.23
4.17 B 3.25% 0.20 0.80 0.25 0.38 13.54 7.04 18 15.82
6.67 CCC 5.00% 0.25 0.75 0.33 0.44 13.60 7.07 18 15.42
9.95 CC 6.00% 0.30 0.70 0.43 0.55 13.71 7.13 18 15.03
0.35 0.65 0.54 0.80 13.96 7.26 19 14.67
14.28 C 7.50%
0.40 0.60 0.67 1.02 14.18 7.37 19 14.32
0.45 0.55 0.82 1.02 14.18 7.37 19 13.92
0.50 0.50 1.00 1.19 14.35 7.46 20 13.58
0.55 0.45 1.22 1.30 14.46 7.52 20 13.22
0.60 0.40 1.50 1.45 14.61 7.60 21 12.88
0.65 0.35 1.86 1.64 14.80 7.70 22 12.56
0.70 0.30 2.33 1.91 15.07 7.84 23 12.29
0.75 0.25 3.00 2.37 15.53 8.08 24 12.10
0.80 0.20 4.00 3.12 16.28 8.47 26 12.05
0.85 0.15 5.67 4.3 17.46 9.08 30 12.24
0.90 0.10 9.00 5.71 18.87 9.81 38 12.59
0.95 0.05 19.00 10 23.16 12.04 60 14.44

Graphic Illustration

Flash Back… Financial Risk…
Pro Forma 1981 for Varying
Actual Percentages of Debt to Total Capital
1981
30% 50% 70%
βU (business risk) 0.82 0.82 0.82 0.82
βL (financial risk) 1.00 1.25 1.82
 With 70% of capital in debt company’s return are 82% more

volatile than that of market
 With 50% of capital in debt company also enjoys benefits of

financial leverage however at lover risk: 25% more riskier than
market

QUESTION 2.
Home Products?


Advantages of Leverage
ADVANTAGES
>>> Tax Shield

>>> Extra cash for expansion and stock
repurchase
>>> Higher EPS (by repurchase stock)
>>> Generate Shareholder wealth by
increase the company value

QUESTION 2.
Home Products?


Disadvantages of Leverage
ADVANTAGES DISADVANTAGES
>>> Tax Shield <<< Increases the company risk

structure
>>> Extra cash for expansion and stock
repurchase <<< LBO will affect the operational side
of the company
>>> Higher EPS (by repurchase stock)
<<< Potential reverse effect
>>> Generate Shareholder wealth by
increase the company value

QUESTION 2.
Home Products?


Tax shield
 Interest is tax-deductable
 The more company borrows the less it pays in tax
Pro Forma 1981 for Varying Percentages of

Debt to Total Capital
Actual 1981 30% 50% 70%
Sales 4,131.20 4,131.20 4,131.20 4,131.20
EBIT 954.80 922.20 922.20 922.2

Interest (2.30) (52.70) (87.80) (122.9)
Profit before taxes 952.50 869.50 834.40 799.3
Taxes (455.20) (417.40) (400.50) (383.7)
Profit after taxes 497.30 452.10 433.90 415.6

QUESTION 2.
Home Products?


Capital Market Reaction
 Market value balance sheet differs from accounting

balance sheet in numbers
Market Value Balance Sheet, $ millions

(Prior to Announcement)
Assets: ???
4,665 Equity: 4,665
($30 × 155.5 shares)
4,665
4,665

Capital Market Reaction – 30% Debt
(Upon Announcement)
Old Assets: 4,665 Equity: 4,665
4,838.856
PV of tax-shield: (0.48 × 362.2) = 173.856 (155.5 shares)
4,838.856 4,838.856
>>> Thus price per share will be $31.12 = 4,838.856 ÷ 155.5 (there are still 155.5 million shares outstanding

(After exchange has taken place)
Old Assets: 4,665 Equity: (4,838.856 -233 -362.2) = 4,243.656
PV of tax-shield: 173.856 (155.5-19.126 = 136.374 shares)
Debt: 362.2
4,838.856 4,838.856
>>> Since price now $31.12 per share, company will buy back only 19.126 million shares = (362.2 + 233) ÷ $31.12
>>> Price per share will be equal $31.12 = 4,243.656 ÷ 136.374 (DIDN’T CHANGE FROM ANNOUNCEMENT!!!)

Capital Market Reaction:
Summary
Price Per
Share
Actual $30.00
30% - 70% $31.12
50% - 50% $31.89
70% - 30% $32.67

QUESTION 2.
Home Products?


Capital
Capital Structure
Structure
Aggressive
Aggressive Capital
Capital Policy
Policy
Structure
Structure Policy
Policy
shareholders
shareholders
Stock
Stock
repurchase
repurchase
QUESTION 3.
financial
financial
leverage
leverage
Debt-equity
Debt-equity Methods
Methods ofof
swap
swap leveraging
leveraging up
up

QUESTION 3.
 How might American Home Products implement more aggressive capital
structure policy?
 What are the alternative methods for leveraging up?

Agressive Capital Structure Policy
 More aggressive capital structure policy =
increase of the portion of debt in a firm's capital
structure
 Ways to implement it differs in the way company

uses the proceeds from new debt issuance
#1 #2 #3
Offer equity-
Repurchase of Finance
debt swap to
stock expansion
its investors

#1: Repurchase of stock
When company uses
proceeds from a new debt
issuance to repurchase its own
stock the price of the stock
goes up
This is a good strategy in

an attempt to improve the
market price of the company
stock, thereby fending off
takeover attempts
 Signal to investors
 Ideal for recapitalization through this method because AHC has
low debt and steady cash flow
 Fend off takeovers

#2: Equity-Debt Swap
 All specified shareholders are given the right to exchange their stock for
a predetermined amount of debt (i.e. bonds) in the same company
 Also known as exchange offers in order to increase leverage

 Stock price will increase
 Market infers that the firm is better off

#2: Equity-Debt Swap cont’…
Illustration:
Assume there is an investor who owns a total of $1,500 in ZXC
Corp stock. ZXC has offered all shareholders the option to swap
their stock for debt at a rate of 1:1, or dollar for dollar. In this
example, the investor would get $1,500 worth of debt if he or
she elected to take the swap.
If, on the other hand, the company really wanted investors to
trade shares for bonds, it can sweeten the deal by offering a swap
ratio of 1:1.5. Since investors would receive $2,250 (1.5 *
$1,500) worth of debt, they essentially gained $750 for just
switching asset classes.

#3: Financing Expansion
ACQUISITION HOROZONTAL
OF STOCK: AQUISITION:
Go straight to the
targeted Take over
company’s rival company
shareholders via
tender offer
 BUT REMEMBER: a firm can borrow certain amount of debt

before the marginal cost of financial distress equals the marginal tax
shield
 A company with low anticipated return/profit will take on less debt
 Vice versa, a more successful one will take on more debt

#3: Financing Expansion Cont’…
Potential Positive Outcome Potential Negative Outcome
Magnified: Magnified:
 company succeed in  Company fails to capitalize on

capitalizing on a business an opportunity, it will be still
opportunity obliged to pay “fixed costs”
 the profit will be magnified  The loss will be magnified
PR
O
SS FI
LO T

QUESTION 3.
structure policy?

Methods for Leveraging Up
 To grow business, company should do resource leverage in an
important small area of business.
 This means that company does financial leverage to its existing

resources:
>>> money,
>>> technology,
>>> human resource,
>>> distribution channel
>>> and market

QUESTION 3.
structure policy?

Capital
Capital Structure
Structure
Distinctive
Distinctive Corporate
Corporate Policy
Policy
Culture
Culture
frugality
frugality
tight
tight financial
financial
control
control
reticence
reticence
QUESTION 4.
financial
financial
conservatism
conservatism
Impressive
Impressive Recapitalization
Recapitalization
Performance
Performance Results
Results Plan
Plan

QUESTION 4.
 In view of AHP’s unique corporate culture, what arguments would you
advance to persuade Mr. Laporte or his successor to adopt your
recommendation?

Mr. Laporte’s Argument
Running Tight financial

Risk Aversion company for control and
shareholders centralization
“companies that are

highly leveraged may
be at risk of bankruptcy
if they are unable to
make payments on their
debt…”

Contra Arguments
“financial
leverage is not
always bad..”
 Financial leverage can increase the shareholders‘

return on their investment
 There are tax-advantages associated with borrowing
 Acquiring stocks or shares of another company is
better than being acquired
 If company uses proceeds from the additional debt
issuance for repurchase of its own stock, it can be
protected from potential takeover

Mr. Laporte’s Argument
“The company has

efficient management of
the assets... Provide
shareholders good return
on their investments…
why shareholders would
be concern with value?”
THE BOTTOM LINE: we are fine without debts..

Contra Arguments Cont’…
“should the firm be acquired by other firm (as

their current position is very inviting) it might
cause damage to the company, especially if the
merger or acquisition does not have synergy..
Let’s say..”
AHP acquires
another company
Issue more debt

after the merger
Tax shield rises
Firm Value Rises

Contra Arguments Cont’…
Again keep in mind that, the BOTTOM LINE:

maintaining the efficiency of asset management &
maximizing the shareholder’s value
“If the firm did not take an initiative to lever up in the

future, they might be taken over by other company…
there is a high risk that what ever good things they
have now might be corrupted by the no synergy
effect…”

QUESTION 4.
 In view of AHP’s unique corporate culture, what arguments would you
advance to persuade Mr. Laporte or his successor to adopt your
recommendation?

THANK YOU!

GOT
QUESTIONS?

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FIN6252 - Financial Planning & Strategy