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American Home Products Capital Structure Case Study.

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Introduction

From: Team Delta American Home Products Capital Structure Case Study Introduction American Home Products is a corporation involved in the production and marketing of over 1,500 consumer goods allocated among four distinct lines of business comprised of prescription drugs, packaged drugs, food products, housewares and household products. While the corporation does not invest heavily into the research and development of new lines of business, its success is a result of its ability to aggressively market the products it manufactures, especially the company's line of prescriptin drugs. American Home Products is a company with virtually no debt and an impressive amount of cash on its balance sheet. Under its current leadership, CEO William F. Laporte maintains an extremely conservative capital structure. During his 17 year tenure, Laporte's brand of centralized micro-management created a company with a clean, low-debt balance sheet; cash reserves equal to 40% of its net worth (Total Assets less Total Liabilities); sales in excess of $4 billion with growth ranging between 10%-15% annually; and remarkable gains in market share while reducing or maintaining a low level of expenses. All this combined with dividend growth of 222% between 1972 - 1981, contributed to the firm's AAA bond rating and to the popularity of AHP's stock among retail and, primarily, institutional investors. ...read more.

Middle

These bonds were high-risk, and thus paid a high interest rate, because little or nothing backed them up. Companies during this period that were most susceptible to the LBO specter were those that were extremely cash-rich. After the takeover, the acquiring group could utilize the cash of the acquired company to either meet the interest payments of the high interest bonds or retire the bonds completely. Maintaining the 30% debt ratio allows the CEO to sustain tight control while avoiding the threat of a LBO. AHP could also leverage its strong balance sheet to borrow along other methods in order to execute a stock repurchase. While AHP certainly possesses the ability to meet additional debt obligations and interest payments, we would continue to argue against greater debt because with added securities outstanding, the possibility of an LBO increases during the high interest rate environment of the 1980s. Additionally, the company's financing needs outside of cash to repurchase outstanding stock is not great considering that AHP does not launch new products until a product has been proven successful in the market. We also would avoid a higher debt ratio from a personal perspective. Due to Mr. Laporte's conservative nature, we do not believe that he would welcome the recommendation of a drastic change to the company's capital structure - a move defined by an increase from 30% to 50 - 70% debt. ...read more.

Conclusion

If AHP were to issue more debt in order to finance the repurchase of outstanding stock, it would maximize shareholder EPS (earnings/outstanding stock) because of the fewer shares outstanding. However, there would also be less profit after tax due to the higher interest payments required with each greater level of debt. In the end, the remaining outstanding shares may not be any better off because the firm would then have the responsibility of making greater interest payments. However, the potential value at 30% is presented with consistent lower interest payments, less variability in required sales, greater profit before tax, as well as more impressive financial ratios and firm net worth. Higher debt ratios at 50 or 70% include greater interest expenses with tax savings, but they also increase the firm's financial risk and to a degree, business risk too. We do not believe that it is a reasonable trade-off. If AHP were financing advances in R&D or product development to increase business operations, we would recommend a greater reliance on debt in order to increase the firm's access to sources of capital. However, this is not the case. What will the capital markets say? Given that our recommendation does not greatly deviate from the current capital structure, we do not anticipate a change in the company's debt rating or share price. Furthermore, management's style of leadership is not jeapordized with the recommended lower portion of debt because it follows the company's historical capital structure. ...read more.

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