43195035-ahpcorp

American Home Products Corporation

Study Case

FIN6252 - Financial Planning & Strategy

CASE INTRODUCTION


Distinctive Corporate Culture


Capital Structure Policy


Impressive Performance Results

Impressive Performance Results Recapitalization

PlanRecapitalization

Plan

reticencereticence

frugalityfrugality

tight financial control


financial conservatism


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

Prescription Drugs Packaged Drugs Food Products Houseware & Home Products

Consumer Products


Well-known Brand Names

“THEY SELL THE

HELL OUT OF

EVERYTHING

THEY’VE GOT”

AHP’s Chief Executive


At the end of 1980, AHP had almost no debt and a cash balance equal to 40% of its net worth

A E B

“I just don’t like to owe money…”

AHP’s Distinctive Culture


RETICENCE

FRUGALITY

&

TIGHT FINANCIAL

CONTROL

CONSERVATISM

&

RISK AVERSION

CENTRALIZING

COMPLETE

AUTHORITY

DISTINCTIVE CORPORATE CULTURE

emanated from its chief executive…

Reticence


21American Home Products

……

… 1

A poll of Wall Street analysts ranked AHP last

in corporate communicability among

21 drug companies

Wall Street Analysts’ Ranking:

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

Exhibit 1.>>> In millions of dollars except per share data

QUESTION 1.


Hamada’s EquationHamada’s Equation Business RiskBusiness Risk

Value to Shareholders

Value to Shareholders

Proposed Capital Structures

Proposed Capital Structures

leverageleverageCapital StructureCapital Structure Financial riskFinancial risk

betabeta

Cost of EquityCost of Equity

Cost of DebtCost of Debt

WACCWACC


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 Risk (βU)Financial Risk (βL)

Business Risk


.

Rc

RM

β

http://www.vias.org/science_cartoons/thumbnails.html

Data Source


.

Data Source (Cont)


.

Regression Analysis


.

β = 0.82

Per sake of study…


.

0.58 -0.46 0.64 1.69 1.04 1.23 1.62 0.68 0.41 0.09 1.32

AHP CO

S&P 500

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% 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

Firm Value


IF and only IF

CHANGES

IN CAP STRUCTURE

BENEFIT

SHAREHOLDERS

THE VALUE

OF THE FIRM

(THE PIE)

INCREASES

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Firm Value


PV of interest tax-shield

Cost of equity of unlevered firm

Dividend Discount Model

Firm Value Under Each Structure



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


30% Debt

50% Debt

70% Debt

Debt Free

BACK TO SHAREHOLDERS

Under the Current Structure


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


Common shares outstanding 135.7 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 $0.94 $3.33 $4.78

ROE 14.66% 51.52% 73.91%7.8%6% 9.6%

50% Debt




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 $0.86 $3.41 $4.95

ROE 17.61% 69.22% 100.55%10.4%14% 13.5%

70% Debt




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 $0.77 $3.49 $5.14

ROE 24.49% 110.52% 162.75%13%23% 18%

Summary


EPS ($/Share)Recession Expected Expansion

Almost debt-free 1.00 3.09 4.36 30% D 0.94 3.33 4.78 50% D 0.86 3.41 4.95 70% D 0.77 3.49 5.14

ROE (%)Recession Expected Expansion

Almost debt-free 10.56 32.62 46.0230% D 14.66 51.52 73.9150% D 17.61 69.22 100.5570% D 24.49 110.52 162.75

Under the expected and expansion scenario leverage increases the returns to shareholders as measured both by ROE and EPS

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

DEBT

EQUITY


QUESTION 1. How much business risk does AHP face?



QUESTION 2.


LeverageLeverage Debts and EquityDebts and Equity

RatingRating

Credit SpreadCredit Spread

Capital Market Reaction


Optimal Capital Structure

Optimal Capital Structure

Financial distressFinancial distress

Break even EBITBreak even EBIT

RecapitalizationRecapitalization


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 CasesCASE 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

Equations:•WACC = RA = (E/V)RE + (D/V)RD

•RE = RA + (RA – RD)(D/E)

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


Capital Structure Under 3 Special CasesCASE I CASE II CASE III

Assumptions:•No corporate taxes•No bankruptcy costs

Assumptions:•Corporate taxes•No bankruptcy costs

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% 50% 70%

D/E 0.43 1.00 2.33

TC 48.00% 48.00% 48.00%

RD 14.00% 14.00% 14.00%

RU 18.00% 18.00% 18.00%

RE 18.89% 20.08% 22.85%

WACC 15.41% 13.68% 11.95%

RE

RD

RD (1-TC)

WACC


Breakeven EBIT Analysis

Almost debt-free

EBIT = 400.00 EBIT = 920.00

Debt 70%

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

But now we need mechanism to incorporate risk of financial distress

In the presence of:

>>> Corporate taxes

>>> Bankruptcy costs

Equations for WACC and RE are still the same…


Rating MechanismD/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

D(D+E)

E(D+E)

DE

Credit Spread%

Interest%

Cost of Debt%

Cost of Equity%

WACC%

0.10 0.90 0.11 0.29 13.45 6.99 18 16.630.15 0.85 0.18 0.33 13.49 7.01 18 16.230.20 0.80 0.25 0.38 13.54 7.04 18 15.820.25 0.75 0.33 0.44 13.60 7.07 18 15.420.30 0.70 0.43 0.55 13.71 7.13 18 15.030.35 0.65 0.54 0.80 13.96 7.26 19 14.670.40 0.60 0.67 1.02 14.18 7.37 19 14.320.45 0.55 0.82 1.02 14.18 7.37 19 13.920.50 0.50 1.00 1.19 14.35 7.46 20 13.580.55 0.45 1.22 1.30 14.46 7.52 20 13.220.60 0.40 1.50 1.45 14.61 7.60 21 12.880.65 0.35 1.86 1.64 14.80 7.70 22 12.560.70 0.30 2.33 1.91 15.07 7.84 23 12.290.75 0.25 3.00 2.37 15.53 8.08 24 12.100.80 0.20 4.00 3.12 16.28 8.47 26 12.050.85 0.15 5.67 4.3 17.46 9.08 30 12.240.90 0.10 9.00 5.71 18.87 9.81 38 12.590.95 0.05 19.00 10 23.16 12.04 60 14.44

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%

Credit Spread + RF RF = 13.16%


Graphic Illustration

Flash Back… Financial Risk…


Actual 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