American Home Products Corporation: Study Case
American Home Products Corporation: Study Case
American Home Products Corporation: Study Case
Study Case
tight
tight financial
financial
CASE
reticence
reticence
control
control
INTRODUCTION
financial
financial
conservatism
conservatism
Impressive
Impressive Recapitalization
Recapitalization
Performance
Performance Results
Results Plan
Plan
AHP’s 1981 sales of more than $4 billion were produced by over 1,500 marketed
brands
Well-known
Brand
Names
A E B
At the end of 1980, AHP had almost no debt and a cash balance equal to 40% of
its net worth
FRUGALITY
FRUGALITY
CONSERVATISM
CONSERVATISM CENTRALIZING
CENTRALIZING
&
&
RETICENCE
RETICENCE &
& COMPLETE
COMPLETE
TIGHT
TIGHT FINANCIAL
FINANCIAL
RISK
RISK AVERSION
AVERSION AUTHORITY
AUTHORITY
CONTROL
CONTROL
… 1
… …
WACC
WACC
Cost
Cost of
of Equity
Equity
Capital Financial
Financial risk
risk
Capital Structure
Structure
leverage
leverage
QUESTION 1.
Value
Value to
to beta
beta
Shareholders
Shareholders
Proposed
Proposed Capital
Capital
Cost
Cost of
of Debt
Debt Structures
Structures
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?
Is used to separate the financial risk of a levered firm from its business risk
It is used to help determine the levered beta and, through this, the optimal
capital structure of corporate firms
Business
Financial Risk
Risk (β
(βUL)
Rc
RM
β = 0.82
.AHP CO
S&P 500
0.58 -0.46 0.64 1.69 1.04 1.23 1.62 0.68 0.41 0.09 1.32
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?
Financial
Risk
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?
Cost of equity of PV of
unlevered firm interest tax-shield
Dividend
Dividend Discount
Discount Model
Model
70% Debt
50% Debt
30% Debt
Debt Free
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?
Optimal
Optimal Capital
Capital
Structure
Structure
Recapitalization
Recapitalization
Financial
Financial distress
distress
QUESTION 2.
Rating
Rating
Capital
Capital Market
Market
Reaction
Reaction
Credit
Credit Spread
Spread
Break
Break even
even EBIT
EBIT
The disadvantages?
Equations: Equations:
•WACC = RA = (E/V)RE + (D/V)RD •RA = (E/V)RE+(D/V)(RD)(1-TC)
•RE = RA + (RA – RD)(D/E) •RE = RU + (RU-RD)(D/E)(1-TC)
Debt 70%
Almost debt-
free
FINANCIAL
DISTRESS
Case III is More Realistic
In the presence of:
>>> Corporate taxes
>>> Bankruptcy costs
RD = RF + Credit Spread
The disadvantages?
ADVANTAGES
The disadvantages?
ADVANTAGES DISADVANTAGES
The disadvantages?
The disadvantages?
>>> Thus price per share will be $31.12 = 4,838.856 ÷ 155.5 (there are still 155.5 million shares outstanding
>>> Since price now $31.12 per share, company will buy back only 19.126 million shares = (362.2 + 233) ÷ $31.12
>>> Price per share will be equal $31.12 = 4,243.656 ÷ 136.374 (DIDN’T CHANGE FROM ANNOUNCEMENT!!!)
Price Per
Share
Actual $30.00
The disadvantages?
shareholders
shareholders
Stock
Stock
repurchase
repurchase
QUESTION 3.
financial
financial
leverage
leverage
Debt-equity
Debt-equity Methods
Methods ofof
swap
swap leveraging
leveraging up
up
#1 #2 #3
Offer equity-
Repurchase of Finance
debt swap to
stock expansion
its investors
Signal to investors
Ideal for recapitalization through this method because AHC has
low debt and steady cash flow
Fend off takeovers
Illustration:
Assume there is an investor who owns a total of $1,500 in ZXC
Corp stock. ZXC has offered all shareholders the option to swap
their stock for debt at a rate of 1:1, or dollar for dollar. In this
example, the investor would get $1,500 worth of debt if he or
she elected to take the swap.
If, on the other hand, the company really wanted investors to
trade shares for bonds, it can sweeten the deal by offering a swap
ratio of 1:1.5. Since investors would receive $2,250 (1.5 *
$1,500) worth of debt, they essentially gained $750 for just
switching asset classes.
PR
O
SS FI
LO T
tight
tight financial
financial
control
control
reticence
reticence
QUESTION 4.
financial
financial
conservatism
conservatism
Impressive
Impressive Recapitalization
Recapitalization
Performance
Performance Results
Results Plan
Plan
AHP acquires
another company
QUESTIONS?