American Home Product

American Home Products

Choice of the Optimal Capital Structure By ab

Case Facts • Company has almost debtfree balance sheet and growing cash reserves(40% of net worth in 1981) • Over 1500 heavily marketed brands in four lines of business : prescription drugs, packaged drugs, food products, houseware & household products • More than $4 billion sales in 1981

AHP’s Corporate Culture

Continued…… •Conservative capital structire : Excess liquidity and low degree of leverage •Primary mission is to make money for its stockholders and to maximise profits by minimising costs •Increased sales, earnings, and dividends for 29 consecutive

Continued…… •Steady growth : 10% to 15% annually •ROE : 25% in 1960 to 30% in 1980 •Financing growth internally while paying out 60% of annual earning as dividends •Price-earning ratio has fallen

Capital Structure Policy •Three alternative capital structures to achieve higher debt ratio 30% debt 50% debt 70% debt •Assumption : AHP issued debt and used the proceeds plus &233 million of excess cash to repurchase stock in early 1981 at the then prevailing stock price of

Our Recommendation • Optimal capital structure should be 70% debt of total capital • Basis of selection: shareholder value maximization • Complies with the company’s mission of

Pros of the Recommended Debt Ratio

Maximize Shareholder’s Value • It has been the company’s mission to give maximum profits to its shareholders • At 70% debt, the EPS and DPS are maximum as shown • Additionally, higher EPS and DPS imply an possible increase in stock price which is beneficial to the

EPS and DPS for Different Capital

Additional Benefits of a Higher Debt Ratio • Return on Equity also increases significantly with increase in Debt ratio • This implies increase in shareholders, value

Continued….. • The PBT reduces due to the interest expense of the additional debt • As a result, there is a significant reduction in the taxable income thereby reducing the corporate taxes

Disadvantages of the Recommendation

Risk Analysis • Business risk: Company has low business risk due to conservative approach towards R&D and the ‘metoo’ approach towards introduction of new products

Continued…… • Financial Risk: Due to a higher debt ratio, its financial risk would increase significantly It may be degraded in the bond rating due to increased exposure to risk thereby increasing the cost of debt

Conclusion

Conclusion • Looking at the company’s mission of increasing shareholders’ value, it should adopt the 70% debt capital structure • We also recommend that the company should continue its strict expenditure control

Thank You!