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  1. 1. Case Study American Home Products Fin 517-01 MTTh 6-9 PM Summer 2015 Dr. Dipasri Ghosh Brendan Perez Fangxu Li Graham Applebaum Piyush Tiwari Rohan Nakrani Tyler Alvino
  2. 2. 1) How much potential value, if any, can AHP create at each of the proposed levels of debt shown in Exhibit 3? To demonstrate the potential value that can be created through leverage we calculated the weighted average cost of capital at each theoretical level of debt financing. The weighted average cost of capital is calculated as: WACC = COSTe(We) + COSTd(Wd). We calculate the unlevered cost of equity capital by using the Dividend Growth rate formula and solving for Ks. The current year dividend, the dividend growth rate, and the stock price are given in the case, and we arrive at an unlevered cost of equity capital of 20.79% (See Appendix 1). We then use the unlevered cost of equity capital to calculate the levered cost of equity in each of the suggested capital structures using the formula in Appendix 2. Debt-EquityRatio COSTs Pre-tax WACC WACC 30:70 23.70% 20.79% 18.77% 50:50 27.58% 20.79% 17.43% 70:30 36.63% 20.79% 16.09% We assume an interest rate on all debt of 14% however, in the calculation of WACC we account for tax savings by calculating COSTd as .14(1-T) where T is the tax rate (See Appendix 2). Once we calculate the WACC we can observe the effect on the value of the company. If we value the company on the basis of free cash flows then it is clear that the lowest WACC and, therefore, highest amount of debt will create the most value within the company. This is the capital structure that will create the most potential value. This is follows MM assumptions I and II in capital structure theory. It is important to note that this potential value is based on some unrealistic assumptions that are addressed below. 2) What capital structure would you recommend as appropriate for AHP? Why? What are the advantages of leveraging this company? What are 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? In general terms, the ideal structure capital structure would be one in which the weighted average cost of capital (WACC) is reduced. The WACC should be lowest where the benefits of tax savings outweigh the costs associated with leverage. In this particular case, since the interest associated with debt is held constant, there is a linear relationship between the WACC and the debt. Therefore, adding the most possible debt will serve to lower the WACC. The main advantage of leveraging the company would be to increase shareholder value. This is achieved by first increasing free cash flows in the form of lower taxes paid and also by decreasing WACC which will increase the valuation of the company. Since the firm can deduct the interest expense for taxes purposes, there will be more cash to distribute to shareholders. The dividends per share will increase as the number of outstanding shares falls via the
  3. 3. repurchase program. Also, earnings per share will increase due to the increase in net income and lower amount of outstanding shares. However, there are several disadvantages to leveraging a company. Since the company has next to no debt as it stands, the firm faces very little bankruptcy risk. However, as soon as they increase the level of debt, the firm faces an increasing exponential bankruptcy risk. As long as the firm continues to generate enough cash to service the debt, bankruptcy will not become an issue. But if the economy becomes weak due to a recession, sales may plummet resulting in less cash on hand. Since the debtors have a fixed priority on cash, the company may have to lower dividends in order to service the debt. An additional issue the firm may run into is lower credit (accounts payable) with vendors since the company’s credit rating may be lowered due to the higher risk of default. This may cause issues with meeting sales order resulting in dissatisfied customers and lower sales in the long run. A key issue that may emerge at the management level is the change in behavior in terms of risk taking. Since a higher portion of the free cash flows generated will go to service the debt, managers may become too risk averse and reject projects with a positive net present value. Since the interest expense that would be paid to bond holders from leveraging up the company is tax deductible, the company’s tax would decrease. This tax shield, the total interest expense multiplied by the company’s tax rate, allows the firm to pay more to investors which is comprised of both shareholders and bondholders. The capital markets would initially react positively towards the stock repurchase with the proceeds from the bonds. However, the extent to which the market reacts favorably depends on the method with which the company repurchases the stocks. If the company is focused on the long-term interests of the shareholders, then the company will repurchase the shares when management feels the stock is undervalued. The company can repurchase in three different ways with the first one being repurchased at their stock at the current market price. They could also purchase the shares in a Dutch auction and a fixed-price tender offer. Based on market data, the fixed-price tender offer yields the highest market reaction. 3) How might AHP implement a more aggressive capital structure policy? What are the alternative methods for leveraging up? In view of AHP’s unique corporate culture, what arguments would you use to persuade Mr. Laporte or his successor to adopt your recommendation? It is relatively easy for AHP to implement a more aggressive capital structure. With proven data of steady cash flows and a superior AAA rating, AHP will have little problems issuing debt. We are suggesting for AHP to issue bonds because they are the cheapest form of debt, but AHP can also decide to take a loan from a bank. Instead of purchasing stock with the cash received, AHP can use the excess cash to purchase machinery, start a R&D branch or acquire another business. Because AHP has a low cost culture that acquires existing products or licenses, this debt will allow AHP to purchase machinery required for new product lines. The new machinery will allow for greater efficiencies in production which is in line with AHP’s methodology. An additional benefit is added through depreciation costs that will lower net income. Most importantly, the machinery will add additional product lines which will increase future cash flows, EBITDA and therefore Enterprise Value.
  4. 4. AHP currently buys existing products, which is expensive because there are large amounts of goodwill costs included. And when licensing AHP, pay a significant portion of profits back to the previous company. If AHP used the debt to start a research and development branch, it can take a 100% of the profits, and does not rely on the negotiations between AHP and its business partners. AHP will be able to increase its future cash flows pretty rapidly, as it would only take a few cash cow products that it then could license or sell at a premium to other companies. Again, it is only a good idea if AHP can increase the cash flows without taking on a crippling amount of debt. Too much debt right away would be bad for AHP because without its own products it is reliant on other businesses. This may even reduce some of AHP’s risk, because AHP is no longer reliant on the contracts it makes with other businesses. Lastly, with enough debt AHP can acquire another business that specializes in manufacturing, or distribution. With AHP already providing great value from its marketing campaign, AHP can focus on this aspect of the business and have another firm worry about the production and/or logistics. By acquiring another company that is a cost leader in either manufacturing or distribution, AHP will be able to leverage their capabilities to pass the cost savings on to AHP and eventually the shareholders. As CEO said “We run the business for the shareholders”. Adding debt to capital will not only reduce the WACC and increase firm value but it increase long term shareholder wealth. This can only be achieved by focusing on long term growth which is achieved by purchasing new products or licenses, starting research and development or becoming more efficient and cost conscious in production and distribution, while maintaining the excellent marketing standards. The tax-savings achieved and higher leverage through debt are icing on top of the cake. And, AHP’s stock price should bounce on the release of the statement to add debt because it will make potential investors and stockholders happy. But, to provide for max shareholder wealth for the long term, AHP must continue to focus on growth and acquiring a safe amount of debt will help achieve this.
  5. 5. Appendix 1 Dividend D1: 1.90 Constant Growth Rate g: 13.6% Stock Price Vs: 30 Formula: Vs = D1 / Ks - g Cost of Equity Ks = Cost of Un leverage Ku : 20.79% Appendix 2 Cost Of Leverage Firm (COSTs) = Ku + D/E ( Ku - KD) WACC = WD x KD ( 1 - T) + WS x Ks Appendix 3 Based on case exhibit 2, 3 and 4 and considering perfect capital market except tax. ($ in millions except per share data) Vu = 155.5 millions Share x $30 Per share = $4,665.00 When take 30% debt Total debt: $362.2 Interest rate: 14% Tax rate= 48% Tax benefit = $362.2 x .14 x .48 = $24.34 After repurchase Share left: 135.7 millions Tax benefit distributed per share: $24.34 / 135.7 millions = $ 0 .1794 per share. This $0.1794 will increase either dividend or share price for the long term shareholders. Note: In real world taking debt and repurchasing share will incur transaction cost which will reduce net income and thus ideal tax benefit amount.