Ahpcorp

FIN6252 - Financial Planning & Strategy
Study Case
American Home Products Corporation
Distinctive Corporate Culture

frugality
Capital Structure Policy
reticence
CASE INTRODUCTION
financial conservatism
tight financial control
Impressive Performance Results
Recapitalization Plan
Description
American Home Products (AHP), is one of the largest pharmaceutical companies in the world
AHPs 1981 sales of more than $4 billion were produced by over 1,500 marketed brands
Four Lines of Business
Prescription Drugs
Packaged Drugs
Food Products
Houseware & Home Products
Consumer Products
Well-known Brand Names
THEY SELL THE HELL

OUT OF EVERYTHING THEYVE GOT
AHPs Chief Executive

I just dont like to owe money
At the end of 1980, AHP had almost no debt and a cash balance equal to 40% of its net worth
AHPs Distinctive Culture
emanated from its chief executive
FRUGALITY RETICENCE & TIGHT FINANCIAL CONTROL
CONSERVATISM & RISK AVERSION
CENTRALIZING COMPLETE AUTHORITY
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 21
American Home Products
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
AHPs 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.
Hamadas Equation
WACC
Business Risk
Cost of Equity
Capital Structure leverage
Financial risk
QUESTION 1.
beta Proposed Capital Structures Cost of Debt
Value to Shareholders
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?
Hamadas 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 Risk (U)
Financial Risk (L)
Business Risk
.
Rc
RM
Data Source
.
Data Source (Cont)

.
Regression Analysis
.
= 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 Risk
how much risk leverage adds to the risk of business
Financial Risk Cont.
Actual 1981
Pro Forma 1981 for Varying Percentages of Debt to Total Capital 30% 50%
48% 1.00 0.82 1.25
70%
48% 2.33 0.82 1.82
T D/E U (business risk) L (financial risk)
47.79%
48% 0.43
0.82
0.82 1.00
QUESTION 1.
Firm Value
CHANGES
IN CAP STRUCTURE BENEFIT SHAREHOLDERS IF and only IF
THE VALUE OF THE FIRM (THE PIE) INCREASES
Firm Value
Cost of equity of unlevered firm
PV of interest tax-shield
Dividend Discount Model
Firm Value Under Each Structure
Pro Forma 1981 for Varying Percentages of Debt to Total Capital 30%
R0 EBIT tc D VU VL Valued Added 0.18 922.2 0.48 376.1 2,664.13 2,844.66 180.53
50%
0.18 922.2 0.48 626.8 2,664.13 2,965.00 300.86
70%
0.18 922.2 0.48 877.6 2,664.13 3,085.38 421.25
Graphic Illustration
70% Debt 50% Debt 30% Debt Debt Free
BACK TO SHAREHOLDERS
Under the Current Structure

Common shares outstanding Taxes Debt Equity 155.5 47.77% 13.9 1472.8
Recession EBIT Interest Profit before taxes Taxes Net Income Dividends on preferred stock Earnings available to common shareholders EPS 300.0 -2.3 297.7 -142.2 155.5 -0.4 155.1 $1.00
Expected 922.2 -2.3 919.9 -439.4 480.5 -0.4 480.1 $3.09
Expansion 1300.0 -2.3 1297.7 -619.9 677.8 -0.4 677.4 $4.36
ROE
10.56%
32.62%
46.02%
30% Debt
Common shares outstanding Taxes Debt Equity 135.7 48% 376.1 877.6
Recession EBIT Interest Profit before taxes Taxes Net Income Dividends on preferred stock Earnings available to common shareholders EPS
6%
Expected 922.2 -52.7 869.5 -417.4 452.2 -0.4 451.8
Expansion 1300.0 -52.7 1247.3 -598.7 648.6 -0.4 648.2
300.0 -52.7 247.3 -118.7 128.6 -0.4 128.2 $0.94
7.8%
$3.33
9.6%
$4.78
ROE
14.66%
51.52%
73.91%
50% Debt
Recession EBIT Interest Profit before taxes Taxes Net Income Dividends on preferred stock Earnings available to common shareholders EPS 300.0 -87.8 212.2 -101.9 110.4 -0.4 110.0
14%
Expected 922.2 -87.8 834.4 -400.5 433.9 -0.4 433.5
Expansion 1300.0 -87.8 1212.2 -581.9 630.4 -0.4 630.0
$0.86
10.4%
$3.41
13.5%
$4.95
ROE
17.61%
69.22%
100.55%
70% Debt
Recession EBIT Interest Profit before taxes Taxes Net Income Dividends on preferred stock Earnings available to common shareholders EPS 300.0 -122.9 177.1 -85.0 92.1 -0.4 91.7
23%
Expected 922.2 -122.9 799.3 -383.7 415.7 -0.4 415.3
Expansion 1300.0 -122.9 1177.1 -565.0 612.1 -0.4 611.7
$0.77
13%
$3.49
18%
$5.14
ROE
24.49%
110.52%
162.75%
Summary
Under the expected and expansion scenario leverage increases the returns to shareholders as measured both by ROE and EPS
Almost debt-free 30% D 50% D 70% D EPS ($/Share) Recession Expected Expansion 1.00 3.09 4.36 0.94 3.33 4.78 0.86 3.41 4.95 0.77 3.49 5.14
However, ROE and EPS much more sensitive to changes in EBIT under financial leverage: as debt increases from 30% to 70% volatility of ROE and EPS also increases
With the increase of leverage shareholders have a potential to receive more value however at the cost of higher risk
EQUITY
DEBT
ROE (%) Recession Expected 10.56 32.62 14.66 51.52 17.61 69.22 24.49 110.52
Expansion 46.02 73.91 100.55 162.75
Almost debt-free 30% D 50% D 70% D
QUESTION 1.
How much business risk does AHP 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?
Leverage
Optimal Capital Structure
Debts and Equity
Recapitalization
Financial distress
QUESTION 2.
Rating Capital Market Reaction Credit Spread Break even 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 companys 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 Assumptions: No corporate taxes No bankruptcy costs Proposition I: The value of the firm is not affected by changes in the capital structure Proposition II: The WACC of firm is NOT affected by capital structure CASE II Assumptions: Corporate taxes No bankruptcy costs Proposition I: The value of the firm increases by the present value of the annual interest tax shield Proposition II: The WACC decreases as D/E increases because of the government subsidy on the interest payments Equations: RA = (E/V)RE+(D/V)(RD)(1-TC) RE = RU + (RU-RD)(D/E)(1-TC) CASE III Assumptions: Corporate taxes Bankruptcy costs As the D/E ratio increases, the probability of bankruptcy increases At some point, the additional value of the interest tax shield will be offset by the increase in expected bankruptcy cost At this point, the value of the firm will start to decrease and the WACC will start to increase as more debt is added
Equations: WACC = RA = (E/V)RE + (D/V)RD RE = RA + (RA RD)(D/E)
Capital Structure Under 3 Special Cases

CASE I Assumptions: No corporate taxes No bankruptcy costs CASE II Assumptions: Corporate taxes No bankruptcy costs CASE III Assumptions: Corporate taxes Bankruptcy costs
CONCLUSIONS: No optimal capital structure
CONCLUSIONS: Optimal capital structure is almost 100% debt Each additional dollar in debt increases the cash flow of the firm
CONCLUSIONS: Optimal capital structure is part debt part equity Occurs where the benefit from an additional dollar of debt is just offset by the increase in expected bankruptcy costs
In Accordance with the Case II
30%
D/E TC RD RU RE WACC 0.43 48.00% 14.00% 18.00% 18.89% 15.41%
50%
1.00 48.00% 14.00% 18.00% 20.08% 13.68%
70%
2.33 48.00% 14.00% 18.00% 22.85% 11.95%
RE RD WACC RD (1-TC)
Breakeven EBIT Analysis

Debt 70%
Almost debtfree
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 0.00 0.41 0.63 1.60 2.50 Rating AAA AA A BBB BB Credit Spread 0.20% 0.50% 1.00% 1.50% 2.00%
4.17
6.67 9.95 14.28
B
CCC CC C
3.25%
5.00% 6.00% 7.50%
RD = RF + Credit Spread
Risk of Financial Distress

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

Actual 1981 Pro Forma 1981 for Varying Percentages of Debt to Total Capital 30%
U (business risk) L (financial risk) 0.82 0.82 1.00
50%
0.82 1.25
70%
0.82 1.82
With 70% of capital in debt companys 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.
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.
Disadvantages of Leverage
ADVANTAGES DISADVANTAGES
>>> Tax Shield

>>> Extra cash for expansion and stock repurchase >>> Higher EPS (by repurchase stock)
<<< Increases the company risk structure <<< LBO will affect the operational side of the company <<< Potential reverse effect
>>> Generate Shareholder wealth by increase the company value
QUESTION 2.
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 Sales EBIT Interest Profit before taxes Taxes Profit after taxes 4,131.20 954.80 (2.30) 952.50 (455.20) 497.30 30% 4,131.20 922.20 (52.70) 869.50 (417.40) 452.10 50% 4,131.20 922.20 (87.80) 834.40 (400.50) 433.90 70% 4,131.20 922.2 (122.9) 799.3 (383.7) 415.6
QUESTION 2.
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

Market Value Balance Sheet, $ millions (Upon Announcement)
Old Assets:
PV of tax-shield:
4,665
(0.48 362.2) = 173.856 4,838.856
Equity:
4,665 4,838.856
(155.5 shares) 4,838.856
>>> Thus price per share will be $31.12 = 4,838.856 155.5 (there are still 155.5 million shares outstanding Market Value Balance Sheet, $ millions (After exchange has taken place) Old Assets: PV of tax-shield: 4,665 173.856 Debt: 4,838.856 Equity: (4,838.856 -233 -362.2) = 4,243.656 (155.5-19.126 = 136.374 shares) 362.2 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 (DIDNT CHANGE FROM ANNOUNCEMENT!!!)
Capital Market Reaction: Summary

Price Per Share Actual 30% - 70% 50% - 50% 70% - 30% $30.00 $31.12 $31.89 $32.67
QUESTION 2.
Aggressive Capital Structure Policy

shareholders
Stock repurchase
QUESTION 3.
Debt-equity swap
financial leverage Methods of leveraging 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
Repurchase of stock
#2
Offer equitydebt swap to its investors
#3
Finance expansion
#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 OF STOCK: Go straight to the targeted companys shareholders via tender offer
HOROZONTAL AQUISITION: Take over rival company
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 Magnified: Potential Negative Outcome Magnified:
company succeed in capitalizing on a business opportunity the profit will be magnified
Company fails to capitalize on an opportunity, it will be still obliged to pay fixed costs The loss will be magnified
QUESTION 3.
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.
Distinctive Corporate Culture

frugality
reticence
tight financial control
QUESTION 4.
financial conservatism Recapitalization Plan
Impressive Performance Results
QUESTION 4.
In view of AHPs unique corporate culture, what arguments would you advance to persuade Mr. Laporte or his successor to adopt your recommendation?
Mr. Laportes Argument

Risk Aversion Running company for shareholders Tight financial control and 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. Laportes 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.. Lets 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 shareholders 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 AHPs unique corporate culture, what arguments would you advance to persuade Mr. Laporte or his successor to adopt your recommendation?
THANK YOU!
GOT QUESTIONS?

Ahpcorp

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FIN6252 - Financial Planning & Strategy

American Home Products Corporation

Distinctive Corporate Culture

Capital Structure Policy

tight financial control

Impressive Performance Results

FIN6252 - Financial Planning & Strategy

Four Lines of Business

Houseware & Home Products

FIN6252 - Financial Planning & Strategy

Well-known Brand Names

FIN6252 - Financial Planning & Strategy

THEY SELL THE HELL

AHPs Chief Executive

FIN6252 - Financial Planning & Strategy

AHPs Distinctive Culture

emanated from its chief executive

FRUGALITY RETICENCE & TIGHT FINANCIAL CONTROL

CONSERVATISM & RISK AVERSION

CENTRALIZING COMPLETE AUTHORITY

DISTINCTIVE CORPORATE CULTURE

Wall Street Analysts Ranking:

American Home Products

Frugality and Tight Financial Control

FIN6252 - Financial Planning & Strategy

Conservatism and Risk Aversion

FIN6252 - Financial Planning & Strategy

Centralyzing Complete Authority

FIN6252 - Financial Planning & Strategy

>>> In millions of dollars except per share data

Capital Structure leverage

FIN6252 - Financial Planning & Strategy

FIN6252 - Financial Planning & Strategy

Business Risk (U)

Financial Risk (L)

FIN6252 - Financial Planning & Strategy

FIN6252 - Financial Planning & Strategy

FIN6252 - Financial Planning & Strategy

Data Source (Cont)

FIN6252 - Financial Planning & Strategy

FIN6252 - Financial Planning & Strategy

Per sake of study

FIN6252 - Financial Planning & Strategy

FIN6252 - Financial Planning & Strategy

how much risk leverage adds to the risk of business

FIN6252 - Financial Planning & Strategy

Financial Risk Cont.

T D/E U (business risk) L (financial risk)

FIN6252 - Financial Planning & Strategy

FIN6252 - Financial Planning & Strategy

THE VALUE OF THE FIRM (THE PIE) INCREASES

FIN6252 - Financial Planning & Strategy

Cost of equity of unlevered firm

Dividend Discount Model

FIN6252 - Financial Planning & Strategy

Firm Value Under Each Structure

FIN6252 - Financial Planning & Strategy

FIN6252 - Financial Planning & Strategy

Under the Current Structure

Expected 922.2 -2.3 919.9 -439.4 480.5 -0.4 480.1 $3.09

Expansion 1300.0 -2.3 1297.7 -619.9 677.8 -0.4 677.4 $4.36

FIN6252 - Financial Planning & Strategy

Expected 922.2 -52.7 869.5 -417.4 452.2 -0.4 451.8