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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? (See Exhibits 1 and 2 )
American Home Products currently has low business risk due to the conservative nature of their business. They piggyback on first movers to lower their research and development costs. They excel in marketing therefore they concentrate on outselling their competitors.
Also, they have low business risk because they are diversified among four product lines: prescription drugs, over the counter drugs, food products, and housewares producing over 1500 products.
Three of American Home Products’ product lines (prescription drugs, over the counter drugs, and food products) are within the defensive industries which mean they have little sensitivity to the business cycle. These industries outperform others even when the economy is bad. In addition, through diversification of manufacturing a variance of product lines, if one product line were to experience a decrease in sales, the other lines should theoretically pick up the slack.
AMH appears to be a healthy company when looking at its financial statements. AMH’s net worth (total assets-total debt) is 1,472.8 million. They have an excess cash of $233 million.
Their ROE, profit margin, ROA, and A/R receivable turnover days all illustrate AMH’s financial strength indicating that they can rapidly generate cash to sustain their current growth rate, at 30.3%, 11.7%, 18.72%, AND 49.73 days respectively. AMH outperforms their industry in all above mentioned ratios.
(See Exhibit #1). However it should be noted that their sales have decreased 5.3% from 14.1% in 1978 to 8.8% in 1981. This foreshadows possible risk in the future. This is why AMH is rethinking their conservative and “tightfisted spending” business approaches.
Currently AMH’s financial performance is strong. (Refer to Exhibit #2). Their high return on equity (ROE) at 30.3% illustrates how much profit the company is generating with the shareholder’s investments. In addition, they have low debt to equity and low debt to asset (debt) ratios both at .005. This further signals their financial strength. From the debt ratios we see that a change decrease in sales or an increase in interest payments would not affect AMH because they have plenty of free cash flow. However the debt ratios also indicate that management may not be responsibly growing the company through the use of leverage and forgoing many opportunities for future growth.
Therefore when you compare the increase of debt alternatives AMH has you can see an increase in debt to equity and debt to debt to asset ratios. For example the debt to equity ratio increases at each level, 30%, 50%, and 70%, to .17,.32, and .513 respectively. The same is true for the debt to asset ratio. It increases to .15,.24,and .34 at 30%,50%,and 70% respectively. Although these could signal financial solvency issues, the industry’s debt to equity ratio is .32, and their debt to asset ratio is .24. This is consistent with the AMH’s 50% debt alternative option. However, the increase of debt adds value to the company.
This is best illustrated when looking at the earnings per share (EPS) and dividend payout ratio. As the debt increases so do both of the above mentioned ratios. EPS consistently increases from 3.18 with no added leverage to 3.33 at 30%, 3.41 at 50%, and 3.49 at 70%. The DPS ratio increase from .597 at no additional leverage to .602 at 70%. Shareholders often interpret an increase in dividends as an increase in confidence of future growth within the company.
AMH is financially strong; however, the provided statistics show it would be best for the company to increase its leverage to a certain level to add more value to the stockholders. If it merely utilizes the excess cash flow of $233 million to repurchase stocks it only adds value to the stockholders in the short run. In the long run AMH should increase their leverage investing in areas such as R&D of new and existing products. This will not only increase value for the company but essentially add value to the stockholders. This reduces AMH’s probable future risk of losing market share to competitors. I believe the certain level is the 30% alternative.
What capital structure would you recommend as appropriate for AHP? 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 the 30% capital structure level. One reason I chose this level is because of the already conservative business atmosphere. This level will receive less resistance for acceptance than the higher levels of 50% and 70%. It still keeps them above the industry on all performance ratios. (Recall that the industry is more consistent with the 50% alternative option.) This will increase their DPS from $1.90 to $2.00. This will increase confidence among investors. Their EPS will increase from 3.18 to 3.33 signally they are increasing value for the stockholders. AMH’s dividend payout ratio will increase from .597 to .601.
Their stock price should also increase from $30.00 to $35.66. This is forecasted by dividing the total market value of common stock ($4,838.56) by the average common shares outstanding (135.7 million). In addition there are other advantages of increase the firm’s leverage. They include: creating a tax shield, generating more free cash flow for future expansions, generating more free cash flow to repurchase stock, a short run increase in EPS due to repurchase of stocks, and overall an increase to the intrinsic value of the company. As always with advantages, disadvantages are present to. They include: an increase in financial risk.
Despite the tax shield, the interest payment will result in a decrease to net income, and the bond rating could decrease to a AA status. The bond rating for a AAA is determined by a 18 Times Interest Earned Ratio. Once AMH increases their leverage to 30%, they will decrease their TIE to 17.50. Whereas, a AA is currently rated around a 9, further debt acquisition could result in a decrease of their bond rating and a decrease in value for stockholders. (Calculation: EBIT/Interest= tie ratio 922.2/52.,7=17.50)
Although the increased leverage decreases the amount of earnings available to stock holders from 496.9 million to 451.7 million for a total of 45.2 million dollars, it has a positive affect for the company’s tax structure. It actually reduces the company’s tax liability by 83 million dollars! Without the debt they have to pay 952.5 million dollars in taxes. However after an increase of 30% leverage, the new tax liability is 869.5 million dollars. Although the accounting value of the stock price appears more significant, the market value of the stock price will increase, too. Since you have to factor in the new liability of $362.2 million dollars for the debt, he new stockholders’ equity will be calculated at $4838.86 less 233 less 362.2 in millions arriving at $4,243.66 reducing the number of stock repurchases by 19.126.. Then dividing the new stockholders’ equity by shares outstanding (136.374) and arriving at the new stock price of $31.12.
3. How might AHP implement a more aggressive capital structure policy? What are the alternative methods for leveraging up?
The obvious alternative for AMH to implement a more aggressive capital structure policy is to acquire more debt by utilizing the other options at 50% or 70%. Alternative methods for leveraging up include: purchasing shares of outstanding stock at the same time as the company issues bonds, create convertible security options for their stockholders where they can turn in stocks for the new bond securities, buy fixed assets, and utilizing derivatives in hedge funds to leverage the company’s assets.
In view of AHP’s unique corporate culture, what arguments would you advance to persuade Mr. Laporte or his successor to adopt your recommendation? The very first thing I will do is show Mr. Laporte my charts that illustrate how increasing debt will bring an increase of overall stockholders wealth. My Laport believes that a company’s main goal is to build value for stockholders, so I will start there. Since, I know he will be still be reluctant, I next will show him how the debt can be repurchased by AHP at a later date if he feels necessary. I will show him that the earnings available at the end of the year for common stockholders are more than the total debt amount.
I will further show him that the net worth of the company is $1,654.5 which also could absorb the costs. (The second option would actually be the better of the two options for repurchase of debt.) Then, I will show Mr. Laporte how the tax advantage will save the company 83 million dollars in the first year! I will reassure him that the financial ratios already illustrate that he has superb management skills and can efficiently and effectively manage the company’s assets, thus he will excel with the new capital structure. Furthermore, the new leverage will still keep the company outperforming competitors within the industry. I will show him the industry ratio chart below. Lastly, I will suggest the increased free cash flow can also be utilized in research and development and perhaps gain a new absolute advantage!
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