American Home Products Corporation
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American Home Products Corporation
Risks of Debt to AHP • At moderate levels – very low: – Enormously profitable company – Numerous entry barriers (brands, patents) – Interest Coverage ratio twice Warner Lambert’s even at 50% debt – Debt can be paid down quickly with internal funds so any capital structure change is easily reversible – Company has no “need” for debt
Risks of Debt to AHP (cont’d) • At moderate levels – very low: – AHP possesses plenty of collateral in cash, A/R, inventory and net fixed assets. – Breakeven EBIT suggests 50% debt plan is superior to all equity plan unless AHP’s EBIT falls by one half! – Bond rating expected to be A or higher – The 50% Debt to Total Capital (B.V.) represents only 14% Debt/T.C. using Market Value of Equity
Why does AHP have no Debt in its Capital Structure? • It does not need debt – it’s a cash cow! – Very profitable – Efficient in utilization of assets
• It doesn’t want debt – Strong integrated corporate culture of Conservatism and Risk Avoidance – Debt policy is focused on minimization of financial risk – Concern for control and secrecy
How can AHP get away with a suboptimal Capital Structure Policy? • The potential gain from correcting the policy is not sufficient to “pay for” capital market discipline (a takeover or proxy fight) designed to correct it. • Shareholders and profit-motivated financial entrepreneurs are powerless to impose a value-maximizing debt policy on AHP management.
Arguments in Favour of Debt • Low business-risk (steady profitability, cash flows, etc.) implies strong (higher than average) debt capacity • Very limited financial risk • Signaling/Financial Advertising • Reversibility • Savings of $40M per year in taxes at 30% Debt level (value of $270M ?)
How to Effect a Change in Capital Structure • Stock Repurchase – Probably not economically efficient if value paid out as repurchase premium wipes out benefits of added debt
• Debt for Stocks securities swap – New debt holders are also shareholders – They effectively receive “dividends” in the form of interest paid out of pre-tax income
• Special Dividend – Best if most SHs are institutions and tax-exempt
Risks of Debt to AHP • At moderate levels – very low: – Enormously profitable company – Numerous entry barriers (brands, patents) – Interest Coverage ratio twice Warner Lambert’s even at 50% debt – Debt can be paid down quickly with internal funds so any capital structure change is easily reversible – Company has no “need” for debt
Risks of Debt to AHP (cont’d) • At moderate levels – very low: – AHP possesses plenty of collateral in cash, A/R, inventory and net fixed assets. – Breakeven EBIT suggests 50% debt plan is superior to all equity plan unless AHP’s EBIT falls by one half! – Bond rating expected to be A or higher – The 50% Debt to Total Capital (B.V.) represents only 14% Debt/T.C. using Market Value of Equity
Why does AHP have no Debt in its Capital Structure? • It does not need debt – it’s a cash cow! – Very profitable – Efficient in utilization of assets
• It doesn’t want debt – Strong integrated corporate culture of Conservatism and Risk Avoidance – Debt policy is focused on minimization of financial risk – Concern for control and secrecy
How can AHP get away with a suboptimal Capital Structure Policy? • The potential gain from correcting the policy is not sufficient to “pay for” capital market discipline (a takeover or proxy fight) designed to correct it. • Shareholders and profit-motivated financial entrepreneurs are powerless to impose a value-maximizing debt policy on AHP management.
Arguments in Favour of Debt • Low business-risk (steady profitability, cash flows, etc.) implies strong (higher than average) debt capacity • Very limited financial risk • Signaling/Financial Advertising • Reversibility • Savings of $40M per year in taxes at 30% Debt level (value of $270M ?)
How to Effect a Change in Capital Structure • Stock Repurchase – Probably not economically efficient if value paid out as repurchase premium wipes out benefits of added debt
• Debt for Stocks securities swap – New debt holders are also shareholders – They effectively receive “dividends” in the form of interest paid out of pre-tax income
• Special Dividend – Best if most SHs are institutions and tax-exempt
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