American Home Product Case

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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 competitors’ products.

In short, AHP is risk-averse and waits to bet on a sure thing. In terms of financial risk, it would increase significantly as the risk of additional debt is shifted to our stockholders. The following points are worth considering to illuminate potential financial risk:

Examining Exhibit 3, we can see the extent to which debt financing increases risk. At 30% debt, the firm is now liable for an additional $362.2 million, $612.9 million at 50% debt, and $863.7 million at 70% debt. •Additional debt contributes to the uncertainty of profit before taxes and EPS. In fact, in Exhibit 3, we can see pro forma estimates of before-tax profits declining due to greater interest expense as the debt ratio increases. In turn, this serves to lower profits after taxes as well at higher levels of debt.

Ultimately, our stockholders will bear the responsibility for more debt. By law, payments must be paid to debtholders, but owners of our equity are guaranteed neither dividends nor capital gains.

With Higher Levels of Debt, Shareholder Value Increases Also

While use of debt increases the firm’s riskiness, it also serves to increase shareholder wealth. By taking on greater levels of debt, AHP will be able to repurchase a larger number of shares, which we estimate will positively affect stock price.

Even though pro forma statements in Exhibit 3 show after-tax profits declining, at 70% debt, enough shares have been repurchased such that EPS has actually increased. •An analysis in Exhibit 3 shows estimated changes in EPS at higher debt ratios. We modeled the impact on AHP’s stock price as the same percentage increase in EPS. As EPS is the most critical factor in a stock’s price, the current market value is likely to rise. •Based on pro forma stock prices, we calculated estimated dividend yields in Exhibit 3 as well. At 70% debt, the yield is actually higher than the current yield. Rising dividends, coupled with higher EPS, should push AHP’s...
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