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- 1. American Home Products A S T U D Y O F C A P I T A L S T R U C T U R E RAE TAO & DANIEL GLASSBERG
- 2. A H P C A P I T A L S T R U C T U R E COMPANY & CASE INTRO
- 3. AHP’s Current Business, Culture & Growth“ One of the most common business platitudes is that a corporation’sprimary mission is to make money for its stockholders ... At American Home, these ideas are a dogmatic way of life.4 LINES OF BUSINESS: RX DRUGS OTC DRUGS FOOD HOUSEHOLD [INTRODUCTION] [ASSUMPTIONS] [RECOMMENDATIONS]
- 4. AHP’s Current Business, Culture & Growth“ One of the most common business platitudes is that a corporation’sprimary mission is to make money for its stockholders ... At American Home, these ideas are a dogmatic way of life.4 LINES OF BUSINESS: RX DRUGS OTC DRUGS FOOD HOUSEHOLD [INTRODUCTION] [ASSUMPTIONS] 5 $ HUNDRED: MINIMUM EXPENDITURE WHERE CEO APPROVAL REQUIRED [RECOMMENDATIONS]
- 5. AHP’s Current Business, Culture & Growth“ One of the most common business platitudes is that a corporation’s11.2primary mission is to make money for its stockholders ... At American Home, these ideas are a dogmatic way of life.4 5 LINES OF BUSINESS: RX DRUGS OTC DRUGS FOOD HOUSEHOLD [INTRODUCTION] [ASSUMPTIONS] $ HUNDRED: MINIMUM EXPENDITURE WHERE CEO APPROVAL REQUIRED % AVG GROWTH RATE FROM 1973-1981 [RECOMMENDATIONS]
- 6. AHP’s Current Conservative Capital Structure1 9 8 0 B A L A N C E S H E E T TOTAL DEBT $13.9 MM [INTRODUCTION] [ASSUMPTIONS] [RECOMMENDATIONS]
- 7. AHP’s Current Conservative Capital Structure 1 9 8 0 B A L A N C E S H E E T TOTAL DEBT $13.9 MM TOTAL DEBT/TOTAL CAPITAL .9% [INTRODUCTION] [ASSUMPTIONS] [RECOMMENDATIONS]
- 8. AHP’s Current Conservative Capital Structure 1 9 8 0 B A L A N C E S H E E T TOTAL DEBT $13.9 MM TOTAL DEBT/TOTAL CAPITAL .9% INTEREST COVERAGE RATIO 436.6x [INTRODUCTION] [ASSUMPTIONS] [RECOMMENDATIONS]
- 9. AHP’s Current Conservative Capital Structure 1 9 8 0 B A L A N C E S H E E T TOTAL DEBT $13.9 MM TOTAL DEBT/TOTAL CAPITAL .9% INTEREST COVERAGE RATIO 436.6x * WA R N E R - L A M B E RT ’ S I N T E R E S T C O V E R AT ER A T I O I S 5 . 0 x , W I T H B O N D S R A T E D A A A / A A . [INTRODUCTION] [ASSUMPTIONS] [RECOMMENDATIONS]
- 10. AHP’s Current Conservative Capital Structure 1 9 8 0 B A L A N C E S H E E T TOTAL DEBT $13.9 MM TOTAL DEBT/TOTAL CAPITAL .9% INTEREST COVERAGE RATIO 436.6x * WA R N E R - L A M B E RT ’ S I N T E R E S T C O V E R AT ER A T I O I S 5 . 0 x , W I T H B O N D S R A T E D A A A / A A . E VA L UAT E I M PAC T O F 3 0 % , 5 0 % , A N D 7 0 % D E B T O F TOTA L C A P I TA L [INTRODUCTION] [ASSUMPTIONS] [RECOMMENDATIONS]
- 11. APV Calculations Given Different Capital StructuresBASE CASE NPV { found FCF through growing perpetuity Ra derived from unlevering Re [INTRODUCTION] [ASSUMPTIONS] [RECOMMENDATIONS]
- 12. APV Calculations Given Different Capital StructuresBASE CASE NPV { found FCF through growing perpetuity Ra derived from unlevering Re+ INTEREST TAX SHIELD { found implied tax rate 2 different assumptions of debt [INTRODUCTION] [ASSUMPTIONS] [RECOMMENDATIONS]
- 13. APV Calculations Given Different Capital StructuresBASE CASE NPV { found FCF through growing perpetuity Ra derived from unlevering Re+ INTEREST TAX SHIELD { found implied tax rate 2 different assumptions of debt+ COSTS OF FNCL DISTRESS { estimated to be ~ 20% of rm value [INTRODUCTION] [ASSUMPTIONS] [RECOMMENDATIONS]
- 14. APV Calculations Given Different Capital StructuresBASE CASE NPV { found FCF through growing perpetuity Ra derived from unlevering Re+ INTEREST TAX SHIELD { found implied tax rate 2 different assumptions of debt+ COSTS OF FNCL DISTRESS { estimated to be ~ 20% of rm valueA D J U S T E D P R E S E N T VA L U E [INTRODUCTION] [ASSUMPTIONS] [RECOMMENDATIONS]
- 15. APV Calculations Given Different Capital StructuresBASE CASE NPV { found FCF through growing perpetuity Ra derived from unlevering Re+ INTEREST TAX SHIELD { found implied tax rate 2 different assumptions of debt+ COSTS OF FNCL DISTRESS { estimated to be ~ 20% of rm valueA D J U S T E D P R E S E N T VA L U E [INTRODUCTION] [ASSUMPTIONS] [RECOMMENDATIONS]
- 16. A H P C A P I T A L S T R U C T U R E ASSUMPTIONS MADE
- 17. Assumption 1: High Growth Rates ~ 8.8%-11.2%S A L E S G ROW T H R AT E 1973 12.4% 1974 14.8% 1975 10.2% 1976 9.4% 1977 8.6% 1978 14.1% 1979 11.1% 1980 11.7% 1981 8.8% Median: 11.1% Mean: 11.2% SD: 2.2% [INTRODUCTION] [ASSUMPTIONS] [RECOMMENDATIONS]
- 18. Assumption 1: High Growth Rates ~ 8.8%-11.2%S A L E S G ROW T H R AT E We assumed the sales growth 1973 12.4% rate, and thus the FCF rm 1974 14.8% growth rate would be consistent 1975 10.2% from the previous 9-year period. 1976 9.4% 1977 8.6% 1978 14.1% _ From these assumptions, we 1979 11.1% developed various Ra. 1980 11.7% 1981 8.8% _ From a normal distrib, the P (FCFInterest Payment)~0%; Median: 11.1% led to assumption of constant Mean: 11.2% SD: 2.2% Rd of 14%. [INTRODUCTION] [ASSUMPTIONS] [RECOMMENDATIONS]
- 19. Assumption 1: High Growth Rates ~ 8.8%-11.2%S A L E S G ROW T H R AT E We assumed the sales growth 1973 12.4% rate, and thus the FCF rm 1974 14.8% growth rate would be consistent 1975 10.2% from the previous 9-year period. 1976 9.4% 1977 8.6% 1978 14.1% - From these assumptions, we 1979 11.1% developed various Ra. 1980 11.7% 1981 8.8% - From a normal distrib, the P (FCFInterest Payment)~0%; Median: 11.1% led to assumption of constant Mean: 11.2% SD: 2.2% Rd of 14%. * I N T E R E S T I N G T O N O T E : I N F L A T I O N W A S B E T W E E N 1 0 - 1 4 % D U R I N G ’ 8 0 - ’ 8 1 . [INTRODUCTION] [ASSUMPTIONS] [RECOMMENDATIONS]
- 20. Assumption 2: 2 Interpretations of Debt1D E B T S TAY S C O N S TA N T given amount of debt stays stable throughout the years as 30-70% of BV’81 leverage: interest tax shield = D x T* [INTRODUCTION] [ASSUMPTIONS] [RECOMMENDATIONS]
- 21. Assumption 2: 2 Interpretations of Debt1D E B T S TAY S C O N S TA N T given amount of debt stays stable throughout the years as 30-70% of BV’81 leverage: interest tax shield = D x T*2TA R G E T L E V E R A G E R AT I O calculated debt to market value ratio in 1981 maintained this target leverage ratio: interest tax shield = using waccme [INTRODUCTION] [ASSUMPTIONS] [RECOMMENDATIONS]
- 22. Assumption 2: 2 Interpretations of Debt1 D E B T S TAY S C O N S TA N T given amount of debt stays stable throughout the years as 30-70% of BV’81 leverage: interest tax shield = D x T*DEBT CONSTANT CAPITAL STRUCTURE 2 Growth Rate 376.1 626.8 877.6 5% 96 161 225 TA R G E T L E V E R A 161 E R AT I O 7% 96 G 225 9% calculated debt to market value ratio in225 96 161 1981 11% 96 161 225 maintained this target leverage ratio: 13% 96 161 225 interest tax shield = using waccme 15% 96 161 225 17% 96 161 225 [INTRODUCTION] [ASSUMPTIONS] [RECOMMENDATIONS]
- 23. Assumption 2: 2 Interpretations of Debt1D E B T S TAY S C O N S TA N T given amount of debt stays stable throughout the years as 30-70% of BV’81 leverage: interest tax shield = D x T*2TA R G E T L E V E R A G E R AT I O calculated debt to market value ratio in 1981 maintained this target leverage ratio: interest tax shield = using waccme [INTRODUCTION] [ASSUMPTIONS] [RECOMMENDATIONS]
- 24. Assumption 2: 2 Interpretations of Debt1DEBT CONSTANT CAPITAL STRUCTURE D E B T S TAY S C O 626.8S TA N877.6 Growth Rate 376.1 N T 5% given amount of debt stays stable throughout 208.70 359.59 521.12 7% the years as 216.90 30-70% of BV’81 leverage: 542.32 373.96 9% 225.27 388.64 564.02 interest tax shield = D x T*403.66 11% 233.81 586.22 13% 242.53 418.99 608.92 15% 251.43 434.65 632.14 2 17% 260.51 450.64 655.86 TA R G E T L E V E R A G E R AT I O calculated debt to market value ratio in 1981 maintained this target leverage ratio: interest tax shield = using waccme [INTRODUCTION] [ASSUMPTIONS] [RECOMMENDATIONS]
- 25. Assumption 3: Minimal Impact of Other Effects { risk-shifting = 0 stable cash ows, shareholders don’t choose riskier NPV projects AG E N C Y C O N F L I C T S [INTRODUCTION] [ASSUMPTIONS] [RECOMMENDATIONS]
- 26. Assumption 3: Minimal Impact of Other Effects { risk-shifting = 0 stable cash ows, shareholders don’t choose riskier NPV projects AG E N C Y manager risk aversion = 0 corporate culture already risk-averse butC O N F L I C T S company still posts strong returns [INTRODUCTION] [ASSUMPTIONS] [RECOMMENDATIONS]
- 27. Assumption 3: Minimal Impact of Other Effects { risk-shifting = 0 stable cash ows, shareholders don’t choose riskier NPV projects AG E N C Y manager risk aversion = 0 corporate culture already risk-averse butC O N F L I C T S company still posts strong returns FCF problems = 0/+ managerial philosophy of frugality and tight nancial control [INTRODUCTION] [ASSUMPTIONS] [RECOMMENDATIONS]
- 28. Assumption 3: Minimal Impact of Other Effects { risk-shifting = 0 stable cash ows, shareholders don’t choose riskier NPV projects AG E N C Y manager risk aversion = 0 corporate culture already risk-averse butC O N F L I C T S company still posts strong returns FCF problems = 0/+ managerial philosophy of frugality and tight nancial controlA S Y M M E T R I C shift from Pecking Order = 0/+ use debt to buy back equity, which can signal that I N F O managers believe rm is undervalued [INTRODUCTION] [ASSUMPTIONS] [RECOMMENDATIONS]
- 29. A H P C A P I T A L S T R U C T U R E FINAL RECOMMENDATIONS
- 30. Recommendation for AHP’s Capital StructureA M E R I C A N H O M E P RO D U C T S CAN INCREASE ITS SHAREHOLDERS’ RETURNS B Y TA K I N G O N M O R E D E B T, E V E N U P TO 7 0 % B O O K VA L U E L E V E R A G E . [INTRODUCTION] [ASSUMPTIONS] [RECOMMENDATIONS]
- 31. Select Financial Data After Capital Structure Shift C U R R E N T R E C O M M E N D E D FIRM VALUE $4447 MM FIRM VALUE $5597 MM LEVERAGE LEVERAGE STOCK PRICE STOCK PRICE [INTRODUCTION] [ASSUMPTIONS] [RECOMMENDATIONS]
- 32. Select Financial Data After Capital Structure Shift C U R R E N T R E C O M M E N D E D FIRM VALUE $4447 MM FIRM VALUE $5597 MM ~15% market LEVERAGE $13.9 MM LEVERAGE value STOCK PRICE STOCK PRICE [INTRODUCTION] [ASSUMPTIONS] [RECOMMENDATIONS]
- 33. Select Financial Data After Capital Structure Shift C U R R E N T R E C O M M E N D E D FIRM VALUE $4447 MM FIRM VALUE $5597 MM ~15% market LEVERAGE $13.9 MM LEVERAGE value STOCK PRICE $30/share STOCK PRICE $39.70/share [INTRODUCTION] [ASSUMPTIONS] [RECOMMENDATIONS]
- 34. T H A N K Y O U ! QUESTIONS?

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