Introduction

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 increase the firm’s leverage: 1. Use of leverage will result in higher EPS and stock price. 2. As stated, will reduce taxable income due to interest tax savings. 3. For firm’s financial discipline, the firm has duty to pay the debt, managers will avoid to spend firm’s capital on wasteful expenditures.

2. a. What is the PV of tax benefits from the three restructuring options given in Exhibit 3? Assume that the company’s debt is perpetual debt.

When a firm uses debt, the interest tax shield provides a corporate tax benefit each year. In order to determine the benefit of leverage for the value of the firm, we must compute the present value of the stream of future interest tax shields the firm will receive. In this special case, we assume that American Home Products issues debt and plans to keep the dollar amount of its debt constant forever. This is referred to as perpetual debt. Therefore, the company has a fixed dollar amount of outstanding debt, rather than an amount that changes with the size of the firm. For example, the company might issue a perpetual bond, making only interest payments but never repaying the principal. More realistically, we suppose that the firm issues short-term debt such as a five-year coupon bond.

At the time the principal is due, the company raises the money needed to pay it by issuing new debt. In this way, the firm never pays off the principal but simply refinances it whenever it comes due. In this situation, the debt is effectively permanent. Important underlying assumptions in these calculations are that the interest rate, the debt amount and the tax rate remain constant, and that the budgeted numbers in the case are right. The first step to compute the present value of the interest tax shield is the determination of the interest expense of the 3 restructuring options. This is the interest rate (14%) times the particular debt amount in each situation.

For the purpose of getting the interest tax shield, we multiply the tax rate (48%) with each of the interest expenses. These tax benefits reflect the savings in taxes resulting from interest payments to debt holders that reduce the EBT. Afterwards, the present value of the interest tax shield of permanent debt can be calculated in two different ways. Firstly, it can be determined with the following formula: PV(Interest Tax Shield) = T*D Under the second method, we have to consider the definition of the present value of the interest tax shield. Taking into account the fact that the debt issued is perpetual, we review that the present value of a perpetuity can be calculated by dividing the amount of cash flows (in this case: interest expense) by its interest rate (PV = CF/i).

Using one of the previous approaches, the present value of the tax benefits ranges from $25.27 (30% debt) to $58.97 (70% debt). We recognize that the tax benefits increase with adding debt. This phenomenon can be derived from the fact that interest expenses increase with additional debt. Assuming the same interest rate, the logical conclusion is that the present value of the interest tax shield goes up if the amount of debt increases.

b. What is the change in the risk of debt from the restructuring using the information for Warner-Lambert and using the information given below for the average debt ratio and coverage ratio (EBIT/interest expenses) for S&P ratings of firms from 1979 to 1981?

Credit rating agencies determine the creditworthiness of companies. In this evaluation the agencies include for example the debtor’s ability to pay back the debt and the likelihood of default. If a company has a poor credit rating, this indicates a high risk of defaulting. We obtain the information about the average debt ratios and interest coverage ratios of the evaluated firms in the different rating categories. In the capital markets, lower bond ratings would result in a higher cost of debt, and actually may negatively impact the stock price, as investors might pay less for a riskier asset to generate a higher required return.

The question is, if American Home Products risk of debt has changed assuming the different proportions of debt. The answer is “yes” and we want to prove our solution with the following argumentation: initially, we computed the company’s debt ratio and interest coverage ratio. The debt ratio is referred to as the debt amount divided by the total assets on the balance sheet. The total assets of AHP in 1981 are $2,588.5. The debt amount varies over the different capital structures from $376.1 to $877.6. The interest coverage ratio can be calculated by dividing EBIT by interest expenses. We already determined EBIT and the associated interest payments for of the three restructuring options in exercise 2a. So, the actual interest coverage is $410.84.

After specified the required ratios, we can compare these to the numbers in the table which provides comparable numbers for S&P ratings of firms. By doing so, we summarize that the risk of debt of AHP will change depending upon the amount of debt they will add to their capital structure. Currently, the company’s bonds are rated triple A. This is going to change if AHP decides to issue more debt. For instance, for 50% debt, it will be downgraded to double A and for 70%, it will be downgraded even more (A).

c. What is the change in ROE across the various debt ratios and the current capital structure?

ROE is defined as NI divided by equity. It measures a corporation’s profitability by revealing how much profit a company generates with the money shareholders have invested. Furthermore, ROE is useful for comparing the profitability of a company to that of other firms in the same industry. But we also have to consider the risk of debt. If the company takes on too much debt, the cost of debt rises as default risk goes up and creditors demand a higher risk premium. Subsequently, ROE decreases.

Looking at American Home Product’s ROE and its changes, we can say that an increase in debt leads to an increase of return on equity. We can support this statement by the fact that ROE is approximately 52% assuming 30% debt and rises up to more than 110%. The green color represents the increase in ROE. If we compare the actual ROE with the one with 30% debt, we can see that it has increased by more than 70%. This movement happens due to the tax savings and the declining equity amount. But we have to keep in mind that higher expected return is accompanied by higher risk.

d. What is the change in financial slack (cash and cash equivalents plus unused debt capacity) for the various debt scenarios and the current capital structure? Initially, we want to clarify the expression “financial slack”. This is referred to as the ready access to cash or debt financing. Therefore, it is calculated by adding up cash, cash equivalents and unused debt capacity. A high financial slack enhances a company’s flexibility and facilitates “surviving” in shortages and recessions. However, associated with an increasing financial slack, there might arise some problems like more difficult control and insufficient discipline.

Currently, American Home Products has a high financial slack because of its financial conservatism. According to the case, AHP has an almost debt-free balance sheet and growing cash reserves. The cash balance is even more than 40% of its net worth. Furthermore, the unused debt capacity is the net worth remaining in each restructuring option. Hence, the current financial slack is more than $2,380.

But with the restructuring, we notice that it decreases which is represented by the numbers shaded in red. With a debt amount of 70%, it accounts for only $736 which represents a reduction of almost 70% relative to the actual financial slack. We conclude that the financial slack decreases as debt amount increases. The cause is simple. AHP takes the excess cash to repurchase shares from its shareholders. Additionally, unused debt capacity decreases as debt amount goes up.

e. How is the ability of the firm to repay its debt different in each of the debt scenarios and the current capital structure?

The ability to repay of a company is an important issue to take into consideration when handling with debt. The ability to repay is determined by the capacity to generate cash from operations, asset sales, or external financial markets. The point is that accumulation of debt involves risk. As debt levels increase, borrowers’ ability to repay becomes progressively more sensitive to drops in income and sales as well as increases in interest rates. The rule of thumb is, the higher debt, the higher is the probability of defaulting. Thus, highly indebted borrowers’ creditworthiness may be downgraded. Consequently, lenders may stop lending. So, consumption and investment must be reduced.

Borrowers are more likely not to be able to make any payments on their debt. As described above, the credit rating agencies that determine a company’s creditworthiness, adapt their rating to an increase of a company’s debt. The company’s bonds might be downgraded, which might affect the cost of debt because lenders require a higher return on the bonds. In this case, American Home Products’ ability to repay its debt will go down if it decides to issue more debt than it does currently, since its bonds may be downgraded depending upon the amount of debt to be issued. On the other hand, AHP expects to grow and it represents a very strong company in its business. Due to the numbers given in the case, its sales grew continuously over the last years, almost 9% in 1981.

By analyzing the ratios calculated in the previous exercises, we have to mention several important points. Firstly, the debt ratio increases since the assets remain constant and the debt amount rises. Simultaneously, the interest coverage ratio of AHP decreases dramatically with additional debt because EBIT declines due to stock repurchases and associated interest losses. Furthermore, the interest expenses go up due to additional debt. These two ratios are very important with regard to the ability to repay its debt because they illustrate the reduction in the ability of repayment. The interest coverage ratio indicates how easily a company can pay interest on outstanding debt. The lower the ratio, the more the company is burdened by debt expense.

That means that American Home Products’ ability to make interest payments on its debt goes down. The debt ratio shows the percentage of a company’s assets that are provided via debt. The higher the ratio, the greater the risk associated with the firm. In addition, a high debt ratio may indicate low borrowing capacity of a company. As we can see, the AHP’s debt ratio increases which exposes the increasing risk of the company.

All these points mentioned above are supported by the calculations of the firm’s financial slack. As it decreases, it shows the reduced flexibility. AHP’s current financial performance is very good since it has high ROE (30.06%) and a low debt to equity ratio (0.9%). However, the pro forma of different debt ratios show that if AHP increases debt ratio, it will face a financial risk of increased debt to equity and debt to asset ratios. In other words, it could face solvency problems in long terms.

3. How much potential value can American Home Products create for its shareholders at each of the proposed levels of debt? How would the capital markets react to a decision by the company to increase the use of debt in its capital structure?

In order to determine the potential value that American Home Products can create for its shareholders at each of the proposed levels of debt, we firstly figured out some basic ratios shown in Exhibit 2. We can derive the debt ratio, DPS, EPS, ROE and interest coverage from the case and former calculations and solutions. Book value per share is determined by net worth divided by the average number of current shares outstanding. Since AHP repurchases stock in each of the proposed debt levels, the number of the shares outstanding reduces the higher the debt level. For instance, with 30% debt there would be only 135.7 million common shares outstanding due to the repurchase of 595.2 million.

Additionally, the amount of net worth is reduced to $877.6. This results in a book value of $6.47. The next challenge was the assessment of the stock price. Assuming that price per share divided by earnings per share is $9.43, the stock price rises from $31.40 with 30% debt to $32.91 with 70% debt. With a debt amount of 70%, the stock price is calculated by multiplying EPS with this ratio of $9.43. Finally, the dividend yield is computed by DPS divided by the stock price. This financial ratio shows how much a company pays out in dividends each year in relation to its share price. In other words, it indicates how much cash flow you are getting for each dollar invested in an equity position. This ratio ensures a minimum stream of cash flow to the investor.

Mentionable is that stock price and dividend yield increase with additional debt. The question remaining is: what is the potential value of the firm if it increases debt? The levered value of the firm is equal to: VL = VU + T*D = [EBIT(1-T)/r0 + T*D r0 is the cost of equity of unlevered firm. We compute it using the Dividend Discount Model: r0=D1/P0 + g = 1.9/30 + 0.12 = 0.1810 g represents the growth and is calculated by (1.9-1.7)/1,7 = 0.1176 T*D is the present value of interest tax shield. Using those formulas, we compute the AHP’s levered value and unlevered value under each structure. (Exhibit 2) The added value to shareholders is VL-VU which conforms exactly to the present value of interest tax shield computed in exercise 2.a.

We state that the amount of potential value that can be added increase with the level of debt. For instance, with 70% debt the potential value is about $421. In comparison, the potential value at the 30% debt level is only $180. This increase in potential value is thanks to the interest tax shield. As the interest tax shield goes up the potential value that can be added goes up. After these calculations, let’s consider the issue about the reaction of the capital market. So far, we have assumed that managers, stockholders, and creditors have the same information.

We have also assumed that the firm’s shares and debt are priced according to their true value. But these assumptions may not always be accurate in practice. Due to asymmetric information, manager’s information about the firm and its future prospects is likely to be superior to that of outside investors. That’s why managers would not issue stock if they thought that the current stock price was undervalued.

Thus, investors often perceive an additional issuance of stock as a negative signal. Consequently, the stock price falls. So, managers can use leverage as a way to convince investors that they have information that the company will grow, even if they cannot prove this grow. Investors are likely to interpret the issuance of debt as a good signal and the stock price goes up. Hence, we can summarize that American Home Products sends a good signal to the capital market if it increases its debt level. The investors may consider its issuance of debt as a good signal and a “prove” of future growth. Subsequently, the stock price may go up.

Recommendations:

According to the financial analysis, we recommend APH’s capital structure change to 70% Debt, 30% Equity. This debt to equity ratio can result in the maximum value of company for the investors according to the ratio analysis especially the EPS and the ROE. Therefore, according to our analysis, the rebuilt capital structure will be satisfying the objectives of the firm.

Additionally, the rebuilt capital structure includes a cost of capital (WACC) that is less than the current cost of capital. This statement can be indicated as less cost for the firm, more profits and opportunities for investment field in the corporation. There is another recommendation, which is hedging and other risk management techniques, in order to stabilize the risks that AHP will be facing with this changed capital structure.

From the management’s viewpoint, we assume that with the changed management, the new area and globalization changing the objective from focusing on shareholders’ value only to stakeholders value will benefit the company.

To be more rational for the company, and rebuilt capital structure will guide the company to reduce the costs for advertisements, since this analysis suggested other ways to boost the value of the firm by depending on the society and employees. For example, now firm can allow to increase their investment on their research and development, while being more aggressive approach to be more productive and creative instead of being conservative or replicating competitors which possibly guide the firm to be left behind in global market.