C3 (Cesar Campos, Swapnil Kumar, Bennett Royce, Shana Singh, Suen

EXHIBIT 1 Selected Financial Data for American Home Products Corporation 1972-1981

1981 1980 1979 1978 1977

Sales ($ mill) $4,131.2 $3,798.5 $3,406.3 $3,062.6 $2,685.1
Cash 729.1 593.3 493.8 436.6 322.9
Total Debt 16.6 13.9 10.3 13.7 10.3
Net Worth 1654.5 1472.8 1322 1178 1035.3
Total Assets ($ mill) 2588.5 2370.3 2090.7 1862.2 1611.3
Net income ($ mill) 497.3 445.9 396 348.4 306.2
Earnings per share 3.18 2.84 2.51 2.21 1.94
Dividends per share $1.90 $1.70 $1.50 $1.33 $1.15

Annual Growth in Sales 8.8% 11.7% 11.1% 14.1% 8.6%

Annual Growth in EPS 12.0% 13.1% 13.6% 13.9% 10.9%
Dividend Payout Ratio 59.7% 60.0% 59.8% 60.0% 59.3%
After Tax Profit Margin 12.0% 11.7% 11.6% 11.4% 11.4%
Return on Equity 30.1% 30.3% 30.0% 29.6% 29.5%

Tax rate 48% (given)

Interest rate 14% (given)

EBT(Earnings before Taxes) 956.3 857.5 761.5 670.0 588.8

Interest expense 2.3 1.9 1.4 1.9 1.4
Interest income 102.1 83.1 69.1 61.1 45.2
EBIT 856.6 776.4 693.8 610.8 545.1

Average

OPM (EBIT/Sales) 20.7% 20.4% 20.4% 19.9% 20.3%

Average 20.6%

• Are yearly OPMs stable or volatile? Is OPM very different than the average during the recessions of 1974-75 and 1980-81?

The OPM values from 1972 to 1981 appear relatively stable, with small fluctuations between 19.6% and 20.7%. The average OPM over t
The range of OPMs is narrow (only about 1% fluctuation), so yearly OPMs can be considered quite stable.

During the recessions, OPM was slightly lower than the average in 1974-75 and slightly above the average in 1980-81, but not dramatical

• What was the lowest OPM that AHP realized during the last 10 years?

Based on your table, the lowest OPM occurred in 1976, with a value of 19.6%
e, Shana Singh, Suengjin Choi)
oration 1972-1981

1976 1975 1974 1973 1972

$2,471.7 $2,258.6 $2,048.7 $1,784.4 $1,587.1
358.8 248.4 194.6 142.8 119.0
7.8 8.4 7.5 6.8 6.3
991.5 -- -- -- --
1510.9 1390.7 1241.6 1126 1042
277.9 250.7 225.6 199.2 172.7
1.75 1.58 1.42 1.25 1.08
$1.00 $0.90 $0.78 $0.63 $0.59

9.4% 10.2% 14.8% 12.4% --

10.8% 11.3% 13.6% 15.7% --
57.1% 57.0% 54.7% 50.0% 54.6%
11.2% 11.1% 11.0% 11.2% 10.9%
28.0% 27.9% 28.2% 28.2% 25.9%

534.4 482.1 433.8 383.1 332.1

1.1 1.2 1.1 1.0 0.9
50.2 34.8 27.2 20.0 16.7
485.3 448.5 407.7 364.0 316.3

20.2%

19.6% 19.9% 19.9% 20.4% 19.9%

Lowest Average 19.9%

cessions of 1974-75 and 1980-81?

6% and 20.7%. The average OPM over the 10-year period is 20.2%

e average in 1980-81, but not dramatically different from the overall average.
• Does AHP rely on a specialized work force that may leave the firm if it was in distress? If so, would these workers be hard to replace

AHP’s workforce is not highly specialized, as its operations are primarily in consumer goods and pharmaceuticals, where labor is relative
But its marketing expertise is crucial to success. If key marketing personnel leave during distress, they would be hard to replace due to the

• Does AHP rely on specialized suppliers that may cease producing custom inputs if AHP were in distress? If so, would these inputs b
AHP does not appear to depend on specialized suppliers that would be difficult to replace. Since the company operates in markets with st

• Does AHP depend on a dealer network to sell its product? Are these dealers likely to switch to selling other products if AHP was clo
AHP uses a dealer network, but dealers are likely to switch to other products if AHP faces distress. Replacing them would be possible but

• Do AHP customers expect continuing support? Is it likely that customers would switch to another product if they thought that AHP
AHP's customers, especially in the pharmaceutical sector, do expect ongoing support, particularly regarding product efficacy and safety.
If customers fear that AHP may not be able to maintain product support during financial distress, they might switch to competitors, leadin

• Is it likely that AHP is vulnerable to competitive attack if it were in financial distress?

Are there other firms who have a strong incentive to compete aggressively (eg lower prices, increase advertising etc) in an attempt t
If so, how effective would such an attack be and how costly would such exacerbated competition be for AHP?
AHP’s competitors might try to exploit its distress with price cuts or advertising, but its conservative financials and diverse products redu

• Does AHP need access to the capital markets to fund future growth opportunities? Does AHP stand to lose considerable value by ha
AHP's need for access to capital markets is relatively low due to its conservative approach to financial management. However, in distress

• Does AHP have many assets that would be sold in liquidation? If AHP were forced to sell assets in the event of a liquidation is it lik
This might occur for example if there are only a few buyers for these assets (specialized assets vs commodities) or if it is likely that
AHP does have tangible assets, including manufacturing and distribution infrastructure. However, in the event of liquidation, these assets

On balance, is AHP’s overall vulnerability low, medium, or high?

On balance, AHP's overall vulnerability to financial distress appears to be low. The company operates conservatively, does not rely o
d these workers be hard to replace?

maceuticals, where labor is relatively easy to replace.

would be hard to replace due to their significant impact.

istress? If so, would these inputs be costly to replace?

mpany operates in markets with standardized inputs, suppliers would be easy to replace without significantly increasing costs.

ing other products if AHP was close to distress? Would these dealers be costly to replace?
placing them would be possible but could increase costs.

product if they thought that AHP was close to distress (i.e. anticipating that AHP would possibly be less likely to provide support in the future)?
rding product efficacy and safety.
might switch to competitors, leading to a loss in market share.

ase advertising etc) in an attempt to exacerbate distress at AHP and hopefully push it out of the market?
be for AHP?
nancials and diverse products reduce vulnerability. Attacks could raise costs, but AHP's strong position would likely limit the impact.

nd to lose considerable value by having to forgo or postpone high NPV activities if it were in distress and unable to raise new finance?
management. However, in distress, it might have to forgo some high-value projects due to restricted access to financing, which could reduce future growth

n the event of a liquidation is it likely that these assets would have to be sold below their “normal” (eg long run) market value?
commodities) or if it is likely that other firms will be selling their assets at exactly the same time and hence temporality flooding the market.
e event of liquidation, these assets could be sold below their long-term market value, particularly if there is low demand or if other companies are liquidat

ates conservatively, does not rely on highly specialized resources, and has manageable risks in terms of competition and asset liquidation.
 provide support in the future)?

y limit the impact.

o raise new finance?

ing, which could reduce future growth opportunities.

market value?
orality flooding the market.
and or if other companies are liquidating at the same time.

and asset liquidation.

i. Estimate the Enterprise Value:
The market value of equity 5,248 (given)
Net debt -712.5
EV (Eneterprise Value) 4,536

ii. Estimate EBITrwc

OPMrwc 19.6%
EBITrwc 811.1

iii. Select a Target Minimum Coverage Ratio C

h 1.5
h ranges from 1 to 3 (where 1 corresponds to cases where the costs of distress are negligible and 3 corresponds to high costs).
Based on the assessment in Q2 that AHP's overall vulnerability is low, we believe it’s not entirely negligible, so we choose 1.5.

iv. Calculate Maximum Interest:

Max Interest (=EBITrwc/h) 540.7

v. Estimate ND*
ND*(=Max Interest/rD) 2,971.1
Where rD = 18.2%

vi. Estimate the Optimal Capital Structure

Optimal Capital Structure 65.5%
(=ND*/EV)
responds to high costs).
gible, so we choose 1.5.
AMERICAN HOME PRODUCTS CORP.
Harvard Business School
Case Software 2-292-701

Copyright (c) 1989 by the President and Fellows of Harvard College.

Developed in conjunction with MicroMentor, Inc., Cambridge, MA.

This case was prepared as a basis for class discussion rather than
to illustrate either effective or ineffective handling of an
administrative situation.
EXHIBIT 1 Selected Financial Data for American Home Products Corporation 1972-1981

1981 1980 1979 1978 1977

Sales ($ mill) $4,131.2 $3,798.5 $3,406.3 $3,062.6 $2,685.1
Cash 729.1 593.3 493.8 436.6 322.9
Total Debt 16.6 13.9 10.3 13.7 10.3
Net Worth 1654.5 1472.8 1322 1178 1035.3
Total Assets ($ mill) 2588.5 2370.3 2090.7 1862.2 1611.3
Net income ($ mill) 497.3 445.9 396 348.4 306.2
Earnings per share 3.18 2.84 2.51 2.21 1.94
Dividends per share $1.90 $1.70 $1.50 $1.33 $1.15

Annual Growth in Sales 8.8% 11.7% 11.1% 14.1% 8.6%

Annual Growth in EPS 12.0% 13.1% 13.6% 13.9% 10.9%
Dividend Payout Ratio 59.7% 60.0% 59.8% 60.0% 59.3%
After Tax Profit Margin 12.0% 11.7% 11.6% 11.4% 11.4%
Return on Equity 30.1% 30.3% 30.0% 29.6% 29.5%
oration 1972-1981

1976 1975 1974 1973 1972

$2,471.7 $2,258.6 $2,048.7 $1,784.4 $1,587.1
358.8 248.4 194.6 142.8 119.0
7.8 8.4 7.5 6.8 6.3
991.5 -- -- -- --
1510.9 1390.7 1241.6 1126 1042
277.9 250.7 225.6 199.2 172.7
1.75 1.58 1.42 1.25 1.08
$1.00 $0.90 $0.78 $0.63 $0.59

9.4% 10.2% 14.8% 12.4% --

10.8% 11.3% 13.6% 15.7% --
57.1% 57.0% 54.7% 50.0% 54.6%
11.2% 11.1% 11.0% 11.2% 10.9%
28.0% 27.9% 28.2% 28.2% 25.9%
EXHIBIT 2 Comparison Data for American Home Products and Warner-Lambert, 1980
($ in million except for per share and ratio data)

American Home Warner-Lambert

Products Corp. Company
Sales $3,798.5 $3,479.2
5-yr compound annual growth rate 11.0% 9.9%
Profit after tax $445.9 $192.7
5-yr 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 Propert, plant and equipment 450.5 827.1
Other 251.9 582.5
Total Assets 2370.3 2957.2
Total Debt 13.9 710.1
Net Worth $1,472.8 $1,482.7

Earnings per share $2.84 $2.41

5-yr compound annual growth rate 12.4% 3.0%
Dividends per share $1.70 $1.32
5-yr 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 (times) 436.6 5
Ratio of Total Debt to Total Capital 0.9% 32.4%
Bond Rating (a) AAA AAA/AA(a)

(a) 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 Structure
($ millions except per share data)

Pro Forma 1981 for

Actual 30% Debt to 50% Debt to
1981 Total Capital Total Capital
Sales $4,131.2 $4,131.2 $4,131.2
EBIT (a) 954.8 922.2 922.2
Interest 2.3 52.7 87.8
Profit before taxes 952.5 869.5 834.4
Taxes 455.2 417.4 400.5
Profit after taxes 497.3 452.1 433.9
Dividends on Pfd. Stock 0.4 0.4 0.4
Earnings Available to 496.9 451.7 433.5
Common Shareholders
Dividends on Common Stock $295.3 $271.0 $260.1
Average Common Shares
Outstanding (millions) 155.5 135.7 127.3
Earnings per Share $3.18 $3.33 $3.41
Dividends per Share $1.90 $2.00 $2.04

BEGINNING OF YEAR: After recapitalization

Cash and Equivalents $593.3 $360.3 $360.3
Total Debt 13.9 376.1 626.8
Net Worth $1,472.8 $877.6 $626.9
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 excess cash used to repurchase stock.
ma 1981 for
70% Debt to
Total Capital
$4,131.2
922.2
122.9
799.3
383.7
415.6
0.4
415.2

$249.1

118.9
$3.49
$2.10

apitalization
$360.3
877.6
$376.1
--

--

cash used to repurchase stock.

EXHIBIT 4 Detailed Assumptions for Pro Forma Recapitalizations

1. Debt is assumed to be added to the capital structure by issuing debt and using the proceeds to repurchase c
repurchases 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 earl

3. The minimum cash balance is assumed to be $360.3 million (equal to Warner-Lambert's 1980 cash balance)
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 foregone on excess cash is assumed to be at a rate of 14% before tax, so with recapitalization, EBIT
cash of $233 million or $32.6 million. Thus, pro forma EBIT is $922.2 million (actual EBIT of $954.8 million m
in interest from excess cash).

8. Details of Recapitalizations (millions of dollars):

30% Debt Ratio 50% Debt Ratio 70% Debt

Excess cash $233.0 $233.0 $233.0
Additional debt 362.2 612.9 863.7
Total repurchase $595.2 $845.9 $1,096.7
Reduction in common shares
outstanding (million shares) 19.8 28.2 36.6
g the proceeds to repurchase common stock. All

e prevailing stock price in early January 1981.

Lambert's 1980 cash balance); thus $233 million in

, so with recapitalization, EBIT falls by .14 times excess

actual EBIT of $954.8 million minus $32.6 reduction

Ratio