American Home Products

Background

1. Big marketing firm

Over $4 billion in annual sales in 1981
Company has almost debt-free balance sheet and growing cash reserves

2. Over 1500 Marketed products in four lines of business

Prescription drugs
Packaged drugs
Food products
Housewares & household products

3. Most profitable business prescription drugs

Antihypertensive drugs (to reduce blood pressure)
Tranquilizers (sleeping drug)
Oral contraceptives (birth control)

4. Corporate Culture
AHP strongly believed in the no-debt policy
AHP was known for its lack of corporate communicability (reticence)
Another component is their managerial philosophy was frugality and tight
financial control
Primary mission was to make money for its stockholders and to maximize profits
by minimizing costs

5. Conservatism and risk-aversion

Avoids risk of new product (drug) development
Products are clever extensions of existing drugs
Relied on strong marketing skill to promote copies of new innovative drugs to
reduce competitions head start advantage

6. Corporate Governance
Centralized authority or management from the top
Ranked 21 in corporate communicability by analysts
CEO works to increase share-holder value
best managed company in the whole pharmaceutical field.

7. Success plan
Laporte is approaching described as brilliant marketer and tightfisted spender

8. Performance
Stable, consistent growth and profitability
 AHP had increased sales, earnings and dividends for 29 consecutive years
Growth in sales above 10%-15% annually
AHPs return on equity had risen from 25% in 1960 to 30% in 1980
60% of earnings paid out as dividends
Price/Earning ratio had fallen by about 60%

9. Capital structure
Investments mostly financed internally
AHP was very conservative with debt and excess liquidity
Even more than other drug firms (which are on average less levered than
companies in other industries)
Warner-Lambert Company as a comparable firm of similar size and in similar
lines of business with interest coverage of 5

Business Risk
Business Risk is very low because
Me-too strategy( no R&D)
Very profitable with stable growth
Barriers to entry (branding and brand loyalty)
Stable demand for medicine
Diversified

Business risk is high because

Centralized management
CEO replacement

Financial Risk
Financial Risk
No debt
Lots of cash
Warner Lambert Company (comparable firm) has market D/V of 30% and
AAA/AA credit rating
Fixed income market

Optimal Capital Structure

1. Potential benefits form leverage

- Interest tax shield
- Free cash flow hypothesis. Repurchase reduces cash holding by $233 million (risk
of excessive perk consumption)

2. Potential costs from leverage

- Bankruptcy costs
 Low likelihood of financial distress

- Asst substitution problem

Under/over investment

3. Tradeoff between interest Tax Shield and expected bankruptcy costs

4. Equity Market Reaction
Increasing the debt ratio creates a tax shield as well as increasing the value of the firm
stock price.

Calculate stock price change for three levels of debt

No change to debt ratio: $30/share
30% debt
50% debt
70% debt
5. Bond marker Reaction
Increasing the debt ratio has potential to affect the band rating based on the ratio of
debt to market value and interest coverage

Examine the financial risk associated with three levels of debt

30% debt
50% debt
70% debt

Equity Market Reaction

Recommendations

The current zero-debt policy of the CEO is not optimal, leverage to ? debt ratio

Firm might lose its AAA bond rating but this is expected to be temporary as the firm
builds cash pretty fast if continues to grow at historical rates