American Home Products

Harvard Business School Case #283-065

Case Software #XLS060

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1. How much business risk does American Home Products face? How much
financial risk would American Home Products face at each of the proposed levels
of debt shown in case Exhibit 3? How much potential value, if any, can American
Home Products create for its shareholders at each of the proposed levels of debt?

2. What capital structure would you recommend as appropriate for American

Home Products? What are the advantages of leveraging this company? the
disadvantages? 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?

3. How might American Home Products implement a more aggressive capital

structure policy? What are the alternative methods for leveraging up?

4. In view of AHP’s unique corporate culture, what arguments would you advance
to persuade Mr. Laporte or his successor to adopt your recommendation?
1. How much business risk does American Home Products face? How much financial risk would American Home Products face
each of the proposed levels of debt shown in case Exhibit 3? How much potential value, if any, can American Home Products c
for its shareholders at each of the proposed levels of debt?

Business Risk
Since the current ratio and quick ratio is good and company is holding more than 25% of its
assets as cash, the business risk is very low. Company is in to pharmaceuticals, food and
house holdproducts. These products are used daily and there will always be market for
these products, therefore Business risk is very low for American Home Products
corporation.

Particulars 1981 1980 1979 1978 1977 1976

Cash 729.1 593.3 493.8 436.6 322.9 358.8

Total assets 2,588.5 2,370.3 2,090.7 1,862.2 1,611.3 1,510.9
Percentage of cash to total asset 28.2 25.0 23.6 23.4 20.0 23.7

Assets 1980
Cash and equivalents $593.3
Accounts receivable $517.3
Inventory $557.3
Net property, plant and equipment $450.5
Other $251.9
Total assets $2,370.3

Liability Amount
Net worth $1,472.8
Total debt $13.9
Current Liability $883.6
Total Liability $2,370.3

Current Asset $1,667.9

Current Liability $883.6
Net working capital $784.3

Current Ratio 1.89

Quick Ratio 1.26
ould American Home Products face at
ny, can American Home Products create

Financial Risk
The level of debt has direct effect on financial risk of the company. Current interest coverage ratio is 415 times which is very
good for the company and as per the projected EBIT depending on the level of debt raised to finance the company the interest
covereage significantly drop in the range of 17.5 to 7.5 times. The sales growth is also slowing and if the operating cost
increases than company will face difficulty in paying interest at high level of debt. The retun on equity will increase drastically if
debt is raised.In future company will find difficult to raise debtif it went for 70% debt financing

Particulars Actual 1981 30% 50% 70%

EBIT 954.8 922.2 922.2 922.2

Interest 2.3 52.7 87.8 122.9
Profit before taxes 952.5 869.5 834.4 799.3
Taxes 455.2 417.4 400.5 383.7
Profit after tax 497.3 452.1 433.9 415.6
Total debt 13.9 376.1 626.8 877.6
Net worth $1,472.8 $877.6 $626.9 $376.1

Return on Capital employed 33.45 36.06 34.61 33.15

Return on equity 33.77 51.52 69.21 110.50
Interest coverage 415.13 17.50 10.50 7.50

Savings in taxes 37.8 54.7 71.5

atio is 415 times which is very
inance the company the interest
and if the operating cost
equity will increase drastically if
2. What capital structure would you recommend as appropriate for American Home Products? What are the
advantages of leveraging this company? the disadvantages? 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?

I would recommend 30% Debt to capital structure to American Home Products.

Advantages
By using debt company would be able to save money on taxes 37.8 million
Its rating will be AAA or AA.
Return on equity will increase by more than 50%

Disadvantages
Increase Interest burden on the company
Company may required loan in future to finance working capital

Particulars 1981 30%

Taxes 455.2 417.4
Saving in taxes 37.8

The capital market will have a positive effect.

The share price of campany will increase as the return on equit has increased by taking less financial risk
 3. How might American Home Products implement a more aggressive capital
structure policy? What are the alternative methods for leveraging up?

American Home products should go for more aggressive capital structure and finance its assets
using debt and sharecapital.

Rather than reducing the sharecapital, company raise debt and invest it into Research and
development and fixed asset. It can upgrade its equipments. Also company can develop in products
using the fiancne raised
4. In view of AHP’s unique corporate culture, what arguments would you advance to
persuade Mr. Laporte or his successor to adopt your recommendation?

As per the companies culture, AHP should work to create wealth for its shareholders. Therefore
company should raise debt to 30% of capital structure. This help company save 38.9m in taxes. It will
increase return on sharecapital. EPS will also increase. This will effect the market price of the share
in positive way. Hence, company should raise debt to 30% of capital employed.
Exhibit 1 Selected Financial Data for American Home Products Corporation, 1972–1981 ($ in millions except per share and ratio data)

1981 1980 1979 1978 1977 1976 1975 1974 1973 1972

Sales $4,131.2 $3,798.5 $3,406.3 $3,062.6 $2,685.1 $2,471.7 $2,258.6 $2,048.7 $1,784.4 $1,587.1
Cash 729.1 593.3 493.8 436.6 322.9 358.8 — — — —
Total debt 16.6 13.9 10.3 13.7 10.3 7.8 — — — —
Net worth 1,654.5 1,472.8 1,322.0 1,178.0 1,035.3 991.5 — — — —
Total assets 2,588.5 2,370.3 2,090.7 1,862.2 1,611.3 1,510.9 1,390.7 1,241.6 1,126.0 1,042.0
Net income 497.3 445.9 396 348.4 306.2 277.9 250.7 255.6 199.2 172.7
Earnings per share 3.18 2.84 2.51 2.21 1.94 1.75 1.58 1.42 1.25 1.08
Dividends per share $1.90 $1.70 $1.50 $1.325 $1.15 $1.00 $0.90 $0.777 $0.625 $0.59

Annual growth in sales 8.8% 11.7% 11.1% 14.1% 8.6% 9.4% 10.2% 14.8% 12.4% —
Annual growth in EPS 12.0 13.1 13.6 13.9 10.9 10.8 11.3 13.6 15.7 —
Dividend payout ratio 59.7 60.0 59.8 60.0 59.3 57.1 57.0 54.7 50.0 54.6%
After-tax profit margin 12.0 11.7 11.6 11.4 11.4 11.2 11.1 11.0 11.2 10.9
Return on equity 30.1% 30.3% 30.0% 29.6% 29.5% 28.0% 27.9% 28.2% 28.2% 25.9%
Exhibit 2 Comparison Data for American Home Products and Warner-Lambert,
1980 ($ in millions except per share and ratio data)

American Home Warner-Lambert

Products Corporation Company

Sales $3,798.5 $3,479.2

5-year compound annual growth rate 11.0% 9.9%
Profit after tax $445.9 $192.7
5-year compound annual growth rate 12.2% 3.3%

Cash and equivalents $593.3 $360.3

Accounts receivable 517.3 541.5
Inventory 557.3 645.8
Net property, plant and equipment 450.5 827.1
Other 251.9 582.5
Total assets 2,370.3 2,957.2
Total debt 13.9 710.1
Net worth $1,472.8 $1,482.7

Earnings per share $2.84 $2.41

5-year compound annual growth rate 12.4% 3.0%
Dividends per share $1.70 $1.32
5-year compound annual growth rate 13.6% 8.0%
Stock price (end of 1980) $30 $20
Price/earnings ratio 10.6 8.3

Profit margin (profit after tax/sales) 11.7% 5.5%

Return on equity 30.3% 13.0%
Interest coverage 436.6X 5.0X
Ratio of total debt to total capital 0.9% 32.4%
Bond rating AAA AAA/AA*

*Warner-Lambert’s debt was rated triple A but analysts felt the firm was close to being
downgraded to double A.
Exhibit 3 Pro Forma 1981 Results for Alternative Capital Structures ($ in millions except per share d

Pro Forma 1981 for

Actual 1981 30% Debt to Total Capital

Sales $4,131.2 $4,131.2

Earnings before
interest and taxesa 954.8 922.2
Interest 2.3 52.7
Profit before taxes 952.5 869.5
Taxes 455.2 417.4
Profit after tax 497.3 452.1
Dividends on preferred
stock 0.4 0.4
Earnings available to
common shareholders 496.9 451.7
Dividends on common
stock $295.3 $271.0
Average common
shares outstanding
(millions) 155.5 135.7
Earnings per share $3.18 $3.33
Dividends per share $1.90 $2.00

Beginning of Year Beginning of Year after Recapitalizati

Cash and equivalents $593.3 $360.3

Total debt 13.9 376.1
Net worth $1,472.8 $877.6
Common stock price $30 —
Aggregate market value
of common stock $4,665.0 —

a
EBIT is reduced in pro forma results due to the loss of interest income from the $233 million in exces
repurchase stock.
al Structures ($ in millions except per share data)

Pro Forma 1981 for

50% Debt to Total Capital 70% Debt to Total Capital

$4,131.2 $4,131.2

922.2 922.2
87.8 122.9
834.4 799.3
400.5 383.7
433.9 415.6

0.4 0.4

433.5 415.2

$260.1 $249.1

127.3 118.9
$3.41 $3.49
$2.04 $2.10

Beginning of Year after Recapitalization

$360.3 $360.3
626.8 877.6
$626.9 $376.1
— —

— —

erest income from the $233 million in excess cash used to

Exhibit 4 Detailed Assumptions for Pro Forma Recapitalizations Presented in Exhibit 3

1. Debt is assumed to be added to the capital structure by issuing debt and using the proceeds to
repurchase common stock. All purchases are assumed to be executed in January 1981.

2. Stock is assumed to be repurchased at a price of $30 per share, which was the prevailing stock
price in early January 1981.

3. The minimum cash balance is assumed to be $360.3 million (equal to Warner-Lambert’s 1980 cash
balance); thus $233 million in excess cash is available for use in repurchasing stock.

4. A tax rate of 48% is used.

5. The common dividend payout ratio is 60%.

6. Interest rate on all debt in all recapitalizations is assumed to be 14% before tax.

7. Interest forgone on excess cash is assumed to be at a rate of 14% before tax, so with
recapitalization EBIT falls by 0.14 times excess cash of $233 million, or $32.6 million. Thus, pro forma
EBIT is $922.2 million (actual EBIT of $954.8 million minus $32.6 million reduction in interest from
excess cash).

8. Details of recapitalizations are ($ millions):

30% Debt Ratio 50% Debt Ratio

Excess cash $233.0 $233.0
Additional debt 362.2 612.9
Total repurchase $595.2 $845.9
Reduction in common
shares outstanding
(millions of shares) 19.8 28.2
s Presented in Exhibit 3

debt and using the proceeds to

uted in January 1981.

, which was the prevailing stock

ual to Warner-Lambert’s 1980 cash

epurchasing stock.

14% before tax.

4% before tax, so with

n, or $32.6 million. Thus, pro forma
million reduction in interest from

70% Debt Ratio

$233.0
863.7
$1,096.7

36.6