American Home Product (AHP) was founded in 1926 with the merging of several small home product companies. As the company expanded in the 1930’s, it acquired companies in different businesses. After World War II, the company had four lines of businesses: prescription drugs, packaged (over-the-counter) drugs, food products, and housewares and household products. Although the name “American Home Product” has never appeared on its products, the firm produces many well-known brands in the market, such as Anacin, Woolite and Chef Boyardee. Starting from the 1960’s, the firm caught a lot of attention with its almost debt-free capital structure. Its chief executive, William F. Laporte, enforced on top-down management system and strict financial policy. His managerial philosophy included the following 4 components: 1.Reticence
According to a poll done by Wall Street, AHP was ranked last in corporate communicability among its competitors in drug industry. 2.Frugality and tight financial control
All expenditure greater than $500 had to be personally approved by the chief executive, Laporte, regardless of the expense was an authorized in the corporate budget. 3.Conservatism and risk-aversion
The company did not develop much new products on its own. They introduced new products by either acquiring or licensing from other firms, or replicating competitors’ products. 4.Centralization of power
Laporte insisted that as the head of the company, he was the top authority. Therefore, he must monitor every aspect of the firm’s operation.
During his tenure, Laporte was able to lead the company into a period of stable, consistent growth and profitability. For 29 consecutive years, AHP had steady increase on its sales, earnings, and dividends. The firm’s price per earnings ratio had fallen, but it had a more than 6 times growth in earnings per share. Due to this huge growth, the value of the stock had triple during Laporte’s era.
As Laporte was coming to retirement in 1981, many analysts were considering recapitalization of AHP’s capital structure. Some believed that zero-debt was a good management strategy while others criticized the firm’s excess liquidity and low degree of leverage. Experts started to assess the firm’s performance under different debt ratio structures: 30% debt, 50% debt and 70% debt. The cooperation’s management team was concerned of finding an appropriate capital structure for AHP.
1. What the benefits and disadvantages of increasing debt in American Home Products? Given qualitative answers based on what you know about how capital structure adds value to firms. The main issue, which AHP is facing, is the capital structure. The capital structure, which AHP had for many years, was fairly successful given the management style by Laporte, however as he gets close to retire we can rationally assume that firm's conservative management cannot be continued, need change in capital structure, and best capital structure which will balance risk and revenue to approach best value of firm's stock price. The AHP's previous capital structure was successful for years, but these assumptions has been ignored: 1. The firm's added costs can be decreased by increasing dept percentage. 2. The opportunity costs and the risks faced by keeping surplus cash amount. 3. The firm is losing opportunities of research and development for more investment to expansion. However, even there are ignored assumptions, these are the disadvantages if AHP increase their dept ratio: 1. By increasing proportions of debt after years of financial conservatism, there is a possibility that AHP’s bond rating would be downgraded, because of the company’s risk increases. 2. Consequently, downgraded bond ratings would result in a higher cost of debt and the stock price may have negative impacts, because investors are willing to pay lower for high risk bonds. Even there are concerns about disadvantages, here are the reasons to...