Recommendation: Optimal Amount of Debt is 70%
As Mr. Laporte approaches retirement, American Home Products (AHP) has an important decision to make with respect to adopting a more aggressive capital structure policy. Use of debt carries with it advantages and disadvantages. In accordance with value-based management, we recommend that AHP adopts a capital structure consisting of 70% debt. The following points justify such action:
The hallmark of value-based management is to choose strategies that add and maximize value for shareholders. •
As noted in Exhibit 3, at higher levels of debt, the company’s EPS increase and they are able to raise dividends per share; these factors are likely to make AHP’s stock more attractive and thereby increase the market price for shareholders.
The Business Week article profiling AHP noted, “One of the most common business platitudes is that a corporation’s primary mission is to make money for its stockholders and to maximize profits…at American Home, these ideas are a dogmatic way of life.” Mr. Laporte readily admits, “We run the business for the shareholders.” Good corporate governance requires that the key shareholder objective, wealth maximization, be implemented. For the purpose of this analysis, wealth is maximized on a per share basis at 70% debt.
With Higher Levels of Debt, Risk Increases
With greater levels of debt, the firm’s total corporate risk increases as measured by business risk and financial risk. Currently, AHP does not face much business risk. The primary cause of this type of risk is sales variability, and we can see from Exhibit 1 that sales have increased steadily each year from 1972-1981. There are numerous reasons why the firm’s risk of operations is so low:
AHP avoids the often-volatile new product development in the drug industry. •
Most new products are acquired of licensed after their development by other firms. •
Many products are either extensions of established products or copies of...
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