1. American Home Products
A S T U D Y O F C A P I T A L S T R U C T U R E
RAE TAO & DANIEL GLASSBERG
2. A H P C A P I T A L S T R U C T U R E
COMPANY & CASE INTRO
3. AHP’s Current Business,
Culture & Growth
“
One of the most common business platitudes is that a corporation’s
primary mission is to make money for its stockholders ... At American
Home, these ideas are a dogmatic way of life.
4 LINES OF BUSINESS:
RX DRUGS
OTC DRUGS
FOOD
HOUSEHOLD
[INTRODUCTION] [ASSUMPTIONS] [RECOMMENDATIONS]
4. AHP’s Current Business,
Culture & Growth
“
One of the most common business platitudes is that a corporation’s
primary mission is to make money for its stockholders ... At American
Home, these ideas are a dogmatic way of life.
4 LINES OF BUSINESS:
RX DRUGS
OTC DRUGS
FOOD
HOUSEHOLD
[INTRODUCTION] [ASSUMPTIONS]
5 $ HUNDRED:
MINIMUM EXPENDITURE
WHERE CEO APPROVAL
REQUIRED
[RECOMMENDATIONS]
5. AHP’s Current Business,
Culture & Growth
“
One of the most common business platitudes is that a corporation’s
11.2
primary mission is to make money for its stockholders ... At American
Home, these ideas are a dogmatic way of life.
4 5 LINES OF BUSINESS:
RX DRUGS
OTC DRUGS
FOOD
HOUSEHOLD
[INTRODUCTION] [ASSUMPTIONS]
$ HUNDRED:
MINIMUM EXPENDITURE
WHERE CEO APPROVAL
REQUIRED
% AVG GROWTH
RATE FROM 1973-1981
[RECOMMENDATIONS]
6. AHP’s Current Conservative
Capital Structure
1 9 8 0 B A L A N C E S H E E T
TOTAL DEBT
$13.9 MM
[INTRODUCTION] [ASSUMPTIONS] [RECOMMENDATIONS]
7. AHP’s Current Conservative
Capital Structure
1 9 8 0 B A L A N C E S H E E T
TOTAL DEBT
$13.9 MM
TOTAL DEBT/TOTAL CAPITAL
.9%
[INTRODUCTION] [ASSUMPTIONS] [RECOMMENDATIONS]
8. AHP’s Current Conservative
Capital Structure
1 9 8 0 B A L A N C E S H E E T
TOTAL DEBT
$13.9 MM
TOTAL DEBT/TOTAL CAPITAL
.9%
INTEREST COVERAGE RATIO
436.6x
[INTRODUCTION] [ASSUMPTIONS] [RECOMMENDATIONS]
9. AHP’s Current Conservative
Capital Structure
1 9 8 0 B A L A N C E S H E E T
TOTAL DEBT
$13.9 MM
TOTAL DEBT/TOTAL CAPITAL
.9%
INTEREST COVERAGE RATIO
436.6x
* WA R N E R - L A M B E RT ’ S I N T E R E S T C O V E R AT E
R A T I O I S 5 . 0 x , W I T H B O N D S R A T E D A A A / A A .
[INTRODUCTION] [ASSUMPTIONS] [RECOMMENDATIONS]
10. AHP’s Current Conservative
Capital Structure
1 9 8 0 B A L A N C E S H E E T
TOTAL DEBT
$13.9 MM
TOTAL DEBT/TOTAL CAPITAL
.9%
INTEREST COVERAGE RATIO
436.6x
* WA R N E R - L A M B E RT ’ S I N T E R E S T C O V E R AT E
R A T I O I S 5 . 0 x , W I T H B O N D S R A T E D A A A / A A .
E VA L UAT E I M PAC T O F 3 0 % , 5 0 % , A N D
7 0 % D E B T O F TOTA L C A P I TA L
[INTRODUCTION] [ASSUMPTIONS] [RECOMMENDATIONS]
11. APV Calculations Given
Different Capital Structures
BASE CASE NPV
{
found FCF through growing perpetuity
Ra derived from unlevering Re
[INTRODUCTION] [ASSUMPTIONS] [RECOMMENDATIONS]
12. APV Calculations Given
Different Capital Structures
BASE CASE NPV
{
found FCF through growing perpetuity
Ra derived from unlevering Re
+ INTEREST TAX SHIELD
{
found implied tax rate
2 different assumptions of debt
[INTRODUCTION] [ASSUMPTIONS] [RECOMMENDATIONS]
13. APV Calculations Given
Different Capital Structures
BASE CASE NPV
{
found FCF through growing perpetuity
Ra derived from unlevering Re
+ INTEREST TAX SHIELD
{
found implied tax rate
2 different assumptions of debt
+ COSTS OF FNCL DISTRESS
{
estimated to be ~ 20%
of rm value
[INTRODUCTION] [ASSUMPTIONS] [RECOMMENDATIONS]
14. APV Calculations Given
Different Capital Structures
BASE CASE NPV
{
found FCF through growing perpetuity
Ra derived from unlevering Re
+ INTEREST TAX SHIELD
{
found implied tax rate
2 different assumptions of debt
+ COSTS OF FNCL DISTRESS
{
estimated to be ~ 20%
of rm value
A D J U S T E D P R E S E N T VA L U E
[INTRODUCTION] [ASSUMPTIONS] [RECOMMENDATIONS]
15. APV Calculations Given
Different Capital Structures
BASE CASE NPV
{
found FCF through growing perpetuity
Ra derived from unlevering Re
+ INTEREST TAX SHIELD
{
found implied tax rate
2 different assumptions of debt
+ COSTS OF FNCL DISTRESS
{
estimated to be ~ 20%
of rm value
A D J U S T E D P R E S E N T VA L U E
[INTRODUCTION] [ASSUMPTIONS] [RECOMMENDATIONS]
16. A H P C A P I T A L S T R U C T U R E
ASSUMPTIONS MADE
17. Assumption 1:
High Growth Rates ~ 8.8%-11.2%
S A L E S G ROW T H R AT E
1973
12.4%
1974
14.8%
1975
10.2%
1976
9.4%
1977
8.6%
1978
14.1%
1979
11.1%
1980
11.7%
1981
8.8%
Median:
11.1%
Mean:
11.2%
SD:
2.2%
[INTRODUCTION] [ASSUMPTIONS] [RECOMMENDATIONS]
18. Assumption 1:
High Growth Rates ~ 8.8%-11.2%
S A L E S G ROW T H R AT E
We assumed the sales growth
1973
12.4%
rate, and thus the FCF rm
1974
14.8%
growth rate would be consistent
1975
10.2%
from the previous 9-year period.
1976
9.4%
1977
8.6%
1978
14.1%
_ From these assumptions, we
1979
11.1%
developed various Ra.
1980
11.7%
1981
8.8%
_ From a normal distrib, the P
(FCFInterest Payment)~0%;
Median:
11.1%
led to assumption of constant
Mean:
11.2%
SD:
2.2%
Rd of 14%.
[INTRODUCTION] [ASSUMPTIONS] [RECOMMENDATIONS]
19. Assumption 1:
High Growth Rates ~ 8.8%-11.2%
S A L E S G ROW T H R AT E
We assumed the sales growth
1973
12.4%
rate, and thus the FCF rm
1974
14.8%
growth rate would be consistent
1975
10.2%
from the previous 9-year period.
1976
9.4%
1977
8.6%
1978
14.1%
- From these assumptions, we
1979
11.1%
developed various Ra.
1980
11.7%
1981
8.8%
- From a normal distrib, the P
(FCFInterest Payment)~0%;
Median:
11.1%
led to assumption of constant
Mean:
11.2%
SD:
2.2%
Rd of 14%.
* I N T E R E S T I N G T O N O T E : I N F L A T I O N W A S B E T W E E N
1 0 - 1 4 % D U R I N G ’ 8 0 - ’ 8 1 .
[INTRODUCTION] [ASSUMPTIONS] [RECOMMENDATIONS]
20. Assumption 2:
2 Interpretations of Debt
1
D E B T S TAY S C O N S TA N T
given amount of debt stays stable throughout
the years as 30-70% of BV’81 leverage:
interest tax shield = D x T*
[INTRODUCTION] [ASSUMPTIONS] [RECOMMENDATIONS]
21. Assumption 2:
2 Interpretations of Debt
1
D E B T S TAY S C O N S TA N T
given amount of debt stays stable throughout
the years as 30-70% of BV’81 leverage:
interest tax shield = D x T*
2
TA R G E T L E V E R A G E R AT I O
calculated debt to market value ratio in 1981
maintained this target leverage ratio:
interest tax shield = using waccme
[INTRODUCTION] [ASSUMPTIONS] [RECOMMENDATIONS]
22. Assumption 2:
2 Interpretations of Debt
1
D E B T S TAY S C O N S TA N T
given amount of debt stays stable throughout
the years as 30-70% of BV’81 leverage:
interest tax shield = D x T*
DEBT CONSTANT
CAPITAL STRUCTURE
2
Growth Rate
376.1
626.8
877.6
5%
96
161
225
TA R G E T L E V E R A 161
E R AT I
O
7%
96
G 225
9%
calculated debt
to market value ratio in225
96 161
1981
11%
96
161
225
maintained this target leverage ratio:
13%
96
161
225
interest tax shield = using waccme
15%
96
161
225
17%
96
161
225
[INTRODUCTION] [ASSUMPTIONS] [RECOMMENDATIONS]
23. Assumption 2:
2 Interpretations of Debt
1
D E B T S TAY S C O N S TA N T
given amount of debt stays stable throughout
the years as 30-70% of BV’81 leverage:
interest tax shield = D x T*
2
TA R G E T L E V E R A G E R AT I O
calculated debt to market value ratio in 1981
maintained this target leverage ratio:
interest tax shield = using waccme
[INTRODUCTION] [ASSUMPTIONS] [RECOMMENDATIONS]
24. Assumption 2:
2 Interpretations of Debt
1
DEBT CONSTANT
CAPITAL STRUCTURE
D E B T S TAY
S C O 626.8S TA N877.6
Growth Rate
376.1 N
T
5%
given amount of
debt stays stable throughout
208.70 359.59
521.12
7%
the years as 216.90
30-70% of BV’81 leverage: 542.32
373.96
9%
225.27
388.64
564.02
interest tax shield = D x T*403.66
11%
233.81
586.22
13%
242.53
418.99
608.92
15%
251.43
434.65
632.14
2
17%
260.51
450.64
655.86
TA R G E T L E V E R A G E R AT I O
calculated debt to market value ratio in 1981
maintained this target leverage ratio:
interest tax shield = using waccme
[INTRODUCTION] [ASSUMPTIONS] [RECOMMENDATIONS]
25. Assumption 3:
Minimal Impact of Other Effects
{
risk-shifting = 0
stable cash ows, shareholders don’t choose riskier
NPV projects
AG E N C Y
C O N F L I C T S
[INTRODUCTION] [ASSUMPTIONS] [RECOMMENDATIONS]
26. Assumption 3:
Minimal Impact of Other Effects
{
risk-shifting = 0
stable cash ows, shareholders don’t choose riskier
NPV projects
AG E N C Y
manager risk aversion = 0
corporate culture already risk-averse but
C O N F L I C T S
company still posts strong returns
[INTRODUCTION] [ASSUMPTIONS] [RECOMMENDATIONS]
27. Assumption 3:
Minimal Impact of Other Effects
{
risk-shifting = 0
stable cash ows, shareholders don’t choose riskier
NPV projects
AG E N C Y
manager risk aversion = 0
corporate culture already risk-averse but
C O N F L I C T S
company still posts strong returns
FCF problems = 0/+
managerial philosophy of frugality and tight
nancial control
[INTRODUCTION] [ASSUMPTIONS] [RECOMMENDATIONS]
28. Assumption 3:
Minimal Impact of Other Effects
{
risk-shifting = 0
stable cash ows, shareholders don’t choose riskier
NPV projects
AG E N C Y
manager risk aversion = 0
corporate culture already risk-averse but
C O N F L I C T S
company still posts strong returns
FCF problems = 0/+
managerial philosophy of frugality and tight
nancial control
A S Y M M E T R I C
shift from Pecking Order = 0/+
use debt to buy back equity, which can signal that
I N F O
managers believe rm is undervalued
[INTRODUCTION] [ASSUMPTIONS] [RECOMMENDATIONS]
29. A H P C A P I T A L S T R U C T U R E
FINAL RECOMMENDATIONS
30. Recommendation for AHP’s
Capital Structure
A M E R I C A N H O M E P RO D U C T S
CAN INCREASE ITS
SHAREHOLDERS’ RETURNS
B Y TA K I N G O N M O R E D E B T,
E V E N U P TO 7 0 % B O O K
VA L U E L E V E R A G E .
[INTRODUCTION] [ASSUMPTIONS] [RECOMMENDATIONS]
31. Select Financial Data After
Capital Structure Shift
C U R R E N T
R E C O M M E N D E D
FIRM VALUE
$4447 MM
FIRM VALUE
$5597 MM
LEVERAGE
LEVERAGE
STOCK PRICE
STOCK PRICE
[INTRODUCTION] [ASSUMPTIONS] [RECOMMENDATIONS]
32. Select Financial Data After
Capital Structure Shift
C U R R E N T
R E C O M M E N D E D
FIRM VALUE
$4447 MM
FIRM VALUE
$5597 MM
~15% market
LEVERAGE
$13.9 MM
LEVERAGE
value
STOCK PRICE
STOCK PRICE
[INTRODUCTION] [ASSUMPTIONS] [RECOMMENDATIONS]
33. Select Financial Data After
Capital Structure Shift
C U R R E N T
R E C O M M E N D E D
FIRM VALUE
$4447 MM
FIRM VALUE
$5597 MM
~15% market
LEVERAGE
$13.9 MM
LEVERAGE
value
STOCK PRICE
$30/share
STOCK PRICE
$39.70/share
[INTRODUCTION] [ASSUMPTIONS] [RECOMMENDATIONS]
