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 sub-
optimal 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