AMERICAN HOME PRODUCTS CORPORATION • The case provides an excellent vehicle for exploring and challenging the notion of optimal capital structure in theory and practice.
• American Home Products is a very successful firm which, according to traditional financial theory, pursues an extremely inefficient capital structure. • AHP has no debt in its capital structure. • Because of its efficiency in asset management and its high level of profitability, AHP does not need debt to finance its operations.
Suggested questions 1. What are the advantages of leveraging this company? The disadvantages? 2. How much business risk does American Home Products face? How much financial risk would American Home Products face at each of proposed levels of debt shown in case Exhibit 3? 3. How would 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? 4. How much potential value, if any, can American Home Products create for its shareholders at each of the proposed levels of debt? 5. In view of AHP’s unique corporate culture, what arguments would you advance to persuade Mr. Laport or his successor to adopt your recommendation? 6. What capital structure would you recommend as appropriate for American Home Products? How might American Home Products implement a more aggressive capital structure policy? What are the alternative methods for leveraging up?
To find out the optimum debt ratio • Estimate of benefits of debt. • Assess the risk associated with the alternative capital structures.
Table 1:DATA on Alternative Capital Structures for AHP Debt ratio= Debt / (Debt + Equity)
Actual (.9%)
30%
50%
70%
EPS DPS (60% of EPS) Book value per share (Net worth/ No. of share) Return on equity (EPS / Book value per share) Interest coverage [ EBIT / Interest ] Stock price at P/E of 9.43 [9.43 x EPS] Break-even P/E for price of $30 [ 30 / EPS] Dividend yield at price of $30 Price at dividend yield of 6.33% Present value of tax savings = t (additional debt + reduction in cash) Aggregate ($million) Per beginning share (155.5 million share)
$3.18 $1.90 $9.47 33.8% 415.1 $30.00 9.43 6.3% $30.00
$3.33 $2.00 $6.47 51.5% 17.5 $31.42 9.01 6.7% $31.58
$3.41 $2.04 $4.92 69.2% 10.5 $32.17 8.80 6.8% $32.31
$3.49 $2.10 $3.16 110.5% 7.5 $32.92 8.60 7.0% $33.16
$0 $0
$285.69 $1.83
$406.03 $2.61
$526.41 $3.39
Table2: DATA on Alternative Capital Structures for AHP ($Million) Debt ratio= Debt / (Debt + Equity)
Actual (.9%)
30%
50%
70%
Earnings available to security holders ( Interest + EAIT )
499.6
504.8
521.7
538.5
Change from actual
0
5.2
22.1
38.9
Cash flow to security holders (Interest+Pre.Div. + Eq. Div.) Change from actual
298.0
324.1
348.3
372.4
0
26.1
50.3
74.4
-37.8
-54.7
-71.5
Taxes, change from actual
Benefits or Returns • Some debt in AHP’s capital structure is clearly beneficial based upon the impact on EPS, DPS, return on equity, earnings available to security holders, and the like. • A key source of benefit is reduced taxes – the benefits accrue to the shareholders. • The company may improve its woeful image with security analysts by signaling more aggressive financial policies. •
This is important since it is not clear from the pricing of AHP’s stock (e.g., its P/E ratio) that the market is rewarding the company sufficiently for its extraordinary performance and the quality of its operating management.
Table 3: DATA on Alternative Capital Structures for AHP ($Million) Debt ratio= Debt / (Debt + Equity)
Actual (.9%)
30%
50%
70%
Risk Impact on net income of 10% reduction in EBIT
10%
10.6% =
11.1%
11.5%
Interest coverage ratio
415.1
10.5
7.5
Stable sales and earnings (see Exhibit 1) Financial flexibility Don’t need external funds Availability Can pay down quickly with internal funding
DFL x 10% = EBIT/(EBIT-R) x10% =(922.2/ 869.5)x10% = 1.06 x 10%
17.5
Risk • Financial Risk • The risk associated with moderate levels of debt (e.g., 30%) is very low. Sensitivity analysis of EBIT implies financial leverage is not very risky. • Interest coverage is twice Warner-Lambert’s even at 50% debt. • Moreover, AHP can pay down debt quickly with internal funds if it so wishes. Thus, the capital structure change is easily reversible.
Business Risk • This is an enormously profitable company with numerous entry barriers (e.g., brands, patents). • AHP is a stable company: Its stability in sales and earnings (see case Exhibit 1) are explained by the fact that it is a large company, well diversified in terms of business, products (1500+), and customers. • In addition, the company has the operating policy which is designed to avoid risks in R&D and new product introductions.
• Management’s tight operating control and monitoring also reduce risk.
• Bond rating analysis suggests the company would receive an A rating even at 50% debt.
• However, the percentage gain in stock price from additional debt is minuscule. Table 1 illustrates that the absolute aggregate gain in equity value is material, but the percentage increase in equity value is tiny. • Reason: • As a growth firm, AHP’s stock price is high relative to its book value (M/B =3). In market value terms, it still is not highly leveraged at 50% book value.
What target debt ratio should AHP have? • The analyses in Tables 1, 2 and 3 suggest that to maximise its stock price AHP should have at least 30% debt. • The optimum probably lies within the rage of 30% - 50% but may be higher. Even at 50%, the risks of financial distress seem to be too low.
How to persuade AHP’s management to adopt a value-maximising debt policy? • AHP’s risk avoidance in operating decisions probably increases shareholder’s wealth, but on the financing side it reduces firm value. • One approach is to appeal to management’s concern for shareholders’ goals by showing the estimated gains in equity. • Moreover, risk is not increased much by reasonable levels of debt, and • Leveraging is easily reversible if management changes its mind.
• One could appeal to other elements of the corporate culture, for example, frugality. • At 30% debt, AHP could save almost $40 million in annual taxes. [t kd D = t kd (additional debt + excess cash used to repurchase shares) = .14x .48 x (376.1 – 13.9 + 233)= 39.99 million.] • If this were a potential saving in operating costs, AHP would not fail to take advantage. • Why donate $40 million a year to the government unnecessarily?
How can the capital structure change be implemented? • Adding debt through a stock repurchase premium would not be economically efficient. The value paid out as a repurchase premium would probably wipe out the minuscule benefits of the added debt. • A debt-for stocks securities swap might be designed to do the job. A swap focuses directly on the increase in earnings available to all security holders from tax savings because the new debt holders are also shareholders. They effectively receive “dividend” in the form of interest paid out of AHP’s pre-tax income. • Another option is to use debt through acquisitions, but the acquisition premiums may well wipe out the benefits.
• Regardless of the approach, AHP would not likely jump immediately to 50% debt. • It would make sense to do it incrementally. • To stay leveraged with its profitability “problem”, AHP would have to increase its payout or continuously engage in repurchases or acquisitions. • Implementation would probably have to wait for the new CEO who has completed PGP from IIML.
Table 2: Bond rating Analysis for AHP Part 1 S&P medians 1979-1981 Debt ratio Interest coverage
AAA
AA
A
17% 24% 30% 18.25 8.57 6.56
BBB
BB
B
39% 3.82
48% 3.27
59% 1.76
Table 2: Bond rating Analysis for AHP Part 2 Warner-Lambert Debt ratio Interest coverage Bond rating
32.4% 5.0 AAA/AA
Table 2: Bond rating Analysis for AHP Part 3 American Home Products Debt ratio
Actual (0.9%)
30%
50%
70%
Interest coverage Bond rating benchmarks Based on S&P interest coverage medians Based on S&P debt ratio medians Based on W-L interest coverage Based on W-L debt ratio
415.1
17.5
10.5
7.5
AAA AAA AAA AAA
AAA A AAA AAA/AA
AAA/AA BB AAA ?
AA/A B/CCC AAA/AA ?
Subjective bond rating (see example)
AAA
AAA
AA/A
BBB/BB
Example at 50% Debt • (1) AHP interest coverage 10.5 • (2) S&P coverage of 8.57 is AA, but with 24% debt versus 50% for AHP. Thus, AHP could lose one category for debt ratio; AHP bond rating is A. • (3) S&P debt ratio of 48% is BB, but with coverage of 3.27 versus 10.5 for AHP. Thus, AHP could gain at least one category for coverage; AHP bond rating is BBB. • (4) AHP coverage is twice that of W-L, but AHP debt ratio is almost twice that of W-L. Thus, AHP bond rating is AA. • (5) AHP has no external financing need. • (5) Thus, at 50% debt, AHP bond rating is probably A, may be AA, and no worse than BBB
Working Notes • Reduction in EBIT = Interest foregone for excess cash to be used for repurchasing shares = $ 233 ml x 14% = $32.62 ml • EBIT before leverage = $954.8 ml • EBIT after leverage = $954.8 ml - $32.62 ml • = $922.2 million • Number of common shares = • Aggregate market value of common shares / MP per share = $4665 ml / $30 = 155.5 ml • EPS = EAIT / N
• Initial Net worth = $1472.8 ml • At 30% Debt to total capital , repurchase of shares = $595.2 ml. • Hence Net worth reduced to $877.6 ml ($1472.8$595.2). • Why has book value per share reduced? • Book value per share has reduced because of repurchase of shares at a premium which is deducted from R&S , a component of Net Worth.
• PV of tax savings = t(Additional Debt + reduction in cash) • At 30% Debt, additional debt = $(376.1 – 13.9) ml = $362.2 • Excess cash used to repurchase of shares= $233.0 • _____________________ • Total = $595.2 ml • PV of tax savings = .48 x $595.2 ml = $285.69 ml
• When debt is 30% of total capital • • • • • •
Debt = $376.1 ml Equity (net worth) = $877.6 ml Total capital = $1253.7 ml 30% of total capital $1253.7 ml = $376.1 ml is debt
