American Home Products Corporation

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% 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