American Home Products

RAE TAO & DANIEL GLASSBERG

A S T U D Y O F C A P I T A L S T R U C T U R E
COMPANY & CASE INTRO
A H P C A P I T A L S T R U C T U R E
[INTRODUCTION] [ASSUMPTIONS] [RECOMMENDATIONS]

AHPs Current Business,
Culture & Growth
One of the most common business platitudes is that a corporations
primary mission is to make money for its stockholders ... At American
Home, these ideas are a dogmatic way of life.
LINES OF BUSINESS:
RX DRUGS
OTC DRUGS
FOOD
HOUSEHOLD
[INTRODUCTION] [ASSUMPTIONS] [RECOMMENDATIONS]

AHPs Current Business,
Culture & Growth
One of the most common business platitudes is that a corporations
primary mission is to make money for its stockholders ... At American
Home, these ideas are a dogmatic way of life.
LINES OF BUSINESS:
RX DRUGS
OTC DRUGS
FOOD
HOUSEHOLD
$ HUNDRED:
MINIMUM EXPENDITURE
WHERE CEO APPROVAL
REQUIRED
[INTRODUCTION] [ASSUMPTIONS] [RECOMMENDATIONS]

AHPs Current Business,
Culture & Growth
One of the most common business platitudes is that a corporations
primary mission is to make money for its stockholders ... At American
Home, these ideas are a dogmatic way of life.
LINES OF BUSINESS:
RX DRUGS
OTC DRUGS
FOOD
HOUSEHOLD
$ HUNDRED:
MINIMUM EXPENDITURE
WHERE CEO APPROVAL
REQUIRED
% AVG GROWTH
RATE FROM 1973-1981
[INTRODUCTION] [ASSUMPTIONS] [RECOMMENDATIONS]
AHPs Current Conservative
Capital Structure
1 9 8 0 B AL ANCE S HE E T
TOTAL DEBT $13.9 MM
[INTRODUCTION] [ASSUMPTIONS] [RECOMMENDATIONS]
AHPs Current Conservative
Capital Structure
1 9 8 0 B AL ANCE S HE E T
TOTAL DEBT $13.9 MM
TOTAL DEBT/TOTAL CAPITAL .9%
[INTRODUCTION] [ASSUMPTIONS] [RECOMMENDATIONS]
AHPs Current Conservative
Capital Structure
1 9 8 0 B AL ANCE S HE E T
TOTAL DEBT $13.9 MM
TOTAL DEBT/TOTAL CAPITAL .9%
INTEREST COVERAGE RATIO 436.6x
[INTRODUCTION] [ASSUMPTIONS] [RECOMMENDATIONS]
AHPs Current Conservative
Capital Structure
1 9 8 0 B AL ANCE S HE E T
TOTAL DEBT $13.9 MM
TOTAL DEBT/TOTAL CAPITAL .9%
INTEREST COVERAGE RATIO 436.6x
* WA R NE R - L A MB E RT S I NT E R E S T C OV E R AT E
R AT I O I S 5 . 0 x , WI T H B ONDS R AT E D A A A / A A .
[INTRODUCTION] [ASSUMPTIONS] [RECOMMENDATIONS]
AHPs Current Conservative
Capital Structure
1 9 8 0 B AL ANCE S HE E T
TOTAL DEBT $13.9 MM
TOTAL DEBT/TOTAL CAPITAL .9%
INTEREST COVERAGE RATIO 436.6x
EVALUATE I MPACT OF 30%, 50%, AND
70% DEBT OF TOTAL CAPI TAL
* WA R NE R - L A MB E RT S I NT E R E S T C OV E R AT E
R AT I O I S 5 . 0 x , WI T H B ONDS R AT E D A A A / A A .
[INTRODUCTION] [ASSUMPTIONS] [RECOMMENDATIONS]
APV Calculations Given
Different Capital Structures
BASE CASE NPV
{
found FCF through growing perpetuity
R
a
derived from unlevering R
e
[INTRODUCTION] [ASSUMPTIONS] [RECOMMENDATIONS]
APV Calculations Given
Different Capital Structures
BASE CASE NPV
+ INTEREST TAX SHIELD
{
found FCF through growing perpetuity
R
a
derived from unlevering R
e
{
found implied tax rate
2 different assumptions of debt
[INTRODUCTION] [ASSUMPTIONS] [RECOMMENDATIONS]
APV Calculations Given
Different Capital Structures
BASE CASE NPV
+ INTEREST TAX SHIELD
+ COSTS OF FNCL DISTRESS
{
found FCF through growing perpetuity
R
a
derived from unlevering R
e
{
found implied tax rate
2 different assumptions of debt
{
estimated to be ~ 20%
of frm value
[INTRODUCTION] [ASSUMPTIONS] [RECOMMENDATIONS]
APV Calculations Given
Different Capital Structures
BASE CASE NPV
+ INTEREST TAX SHIELD
+ COSTS OF FNCL DISTRESS
{
found FCF through growing perpetuity
R
a
derived from unlevering R
e
{
found implied tax rate
2 different assumptions of debt
{
estimated to be ~ 20%
of frm value
ADJ US TE D P RE S E NT VAL UE
[INTRODUCTION] [ASSUMPTIONS] [RECOMMENDATIONS]
APV Calculations Given
Different Capital Structures
BASE CASE NPV
+ INTEREST TAX SHIELD
+ COSTS OF FNCL DISTRESS
{
found FCF through growing perpetuity
R
a
derived from unlevering R
e
{
found implied tax rate
2 different assumptions of debt
{
estimated to be ~ 20%
of frm value
ADJ US TE D P RE S E NT VAL UE
ASSUMPTIONS MADE
A H P C A P I T A L S T R U C T U R E
[INTRODUCTION] [ASSUMPTIONS] [RECOMMENDATIONS]
Assumption 1:
High Growth Rates ~ 8.8%-11.2%
SALES GROWTH RATE
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]
We assumed the sales growth
rate, and thus the FCF frm
growth rate would be consistent
from the previous 9-year period.
_ From these assumptions, we
developed various R
a
.
_ From a normal distrib, the P
(FCF<Interest Payment)~0%;
led to assumption of constant
R
d
of 14%.
SALES GROWTH RATE
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%
Assumption 1:
High Growth Rates ~ 8.8%-11.2%
[INTRODUCTION] [ASSUMPTIONS] [RECOMMENDATIONS]
Assumption 1:
High Growth Rates ~ 8.8%-11.2%
We assumed the sales growth
rate, and thus the FCF frm
growth rate would be consistent
from the previous 9-year period.
- From these assumptions, we
developed various R
a
.
- From a normal distrib, the P
(FCF<Interest Payment)~0%;
led to assumption of constant
R
d
of 14%.
* I NT E R E S T I NG TO NOT E : I NF L AT I ON WA S B E T WE E N
1 0 - 1 4 % D U R I NG 8 0 - 8 1 .
SALES GROWTH RATE
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]
Assumption 2:
2 Interpretations of Debt
DE B T S TAYS CONS TANT
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]
Assumption 2:
2 Interpretations of Debt
DE B T S TAYS CONS TANT
given amount of debt stays stable throughout
the years as 30-70% of BV
81
leverage:
interest tax shield = D x T*

TARGE T L E VE RAGE RATI O
calculated debt to market value ratio in 1981 &
maintained this target leverage ratio:
interest tax shield = using wacc
me
[INTRODUCTION] [ASSUMPTIONS] [RECOMMENDATIONS]
TARGE T L E VE RAGE RATI O
calculated debt to market value ratio in 1981 &
maintained this target leverage ratio:
interest tax shield = using wacc
me
Assumption 2:
2 Interpretations of Debt
DE B T S TAYS CONS TANT
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
Growth Rate 376.1 626.8 877.6
5% 96 161 225
7% 96 161 225
9% 96 161 225
11% 96 161 225
13% 96 161 225
15% 96 161 225
17% 96 161 225
[INTRODUCTION] [ASSUMPTIONS] [RECOMMENDATIONS]
Assumption 2:
2 Interpretations of Debt
DE B T S TAYS CONS TANT
given amount of debt stays stable throughout
the years as 30-70% of BV
81
leverage:
interest tax shield = D x T*

TARGE T L E VE RAGE RATI O
calculated debt to market value ratio in 1981 &
maintained this target leverage ratio:
interest tax shield = using wacc
me
[INTRODUCTION] [ASSUMPTIONS] [RECOMMENDATIONS]
DE B T S TAYS CONS TANT
given amount of debt stays stable throughout
the years as 30-70% of BV
81
leverage:
interest tax shield = D x T*

Assumption 2:
2 Interpretations of Debt
DEBT CONSTANT CAPITAL STRUCTURE
Growth Rate 376.1 626.8 877.6
5% 208.70 359.59 521.12
7% 216.90 373.96 542.32
9% 225.27 388.64 564.02
11% 233.81 403.66 586.22
13% 242.53 418.99 608.92
15% 251.43 434.65 632.14
17% 260.51 450.64 655.86
TARGE T L E VE RAGE RATI O
calculated debt to market value ratio in 1981 &
maintained this target leverage ratio:
interest tax shield = using wacc
me
[INTRODUCTION] [ASSUMPTIONS] [RECOMMENDATIONS]
Assumption 3:
Minimal Impact of Other Effects
AGENCY
CONFLI CTS
risk-shifting = 0
stable cash fows, shareholders dont choose riskier
NPV projects

{
[INTRODUCTION] [ASSUMPTIONS] [RECOMMENDATIONS]
Assumption 3:
Minimal Impact of Other Effects
AGENCY
CONFLI CTS
risk-shifting = 0
stable cash fows, shareholders dont choose riskier
NPV projects

manager risk aversion = 0
corporate culture already risk-averse but
company still posts strong returns

{
[INTRODUCTION] [ASSUMPTIONS] [RECOMMENDATIONS]
Assumption 3:
Minimal Impact of Other Effects
AGENCY
CONFLI CTS
risk-shifting = 0
stable cash fows, shareholders dont choose riskier
NPV projects

manager risk aversion = 0
corporate culture already risk-averse but
company still posts strong returns

FCF problems = 0/+
managerial philosophy of frugality and tight
fnancial control

{
[INTRODUCTION] [ASSUMPTIONS] [RECOMMENDATIONS]
Assumption 3:
Minimal Impact of Other Effects
AGENCY
CONFLI CTS
risk-shifting = 0
stable cash fows, shareholders dont choose riskier
NPV projects

manager risk aversion = 0
corporate culture already risk-averse but
company still posts strong returns

FCF problems = 0/+
managerial philosophy of frugality and tight
fnancial control

ASYMMETRI C
I NFO
shift from Pecking Order = 0/+
use debt to buy back equity, which can signal that
managers believe frm is undervalued

{
FINAL RECOMMENDATIONS
A H P C A P I T A L S T R U C T U R E
[INTRODUCTION] [ASSUMPTIONS] [RECOMMENDATIONS]
Recommendation for AHPs
Capital Structure
AME RI CAN HOME P RODUCTS
CAN I NCRE AS E I TS
S HARE HOL DE RS RE TURNS
B Y TAKI NG ON MORE DE B T,
E VE N UP TO 7 0 % B OOK
VAL UE L E VE RAGE .
[INTRODUCTION] [ASSUMPTIONS] [RECOMMENDATIONS]
Select Financial Data After
Capital Structure Shift
FIRM VALUE $4447 MM
LEVERAGE
STOCK PRICE
CURRENT
FIRM VALUE $5597 MM
LEVERAGE
STOCK PRICE
RECOMMENDED
[INTRODUCTION] [ASSUMPTIONS] [RECOMMENDATIONS]
Select Financial Data After
Capital Structure Shift
FIRM VALUE $4447 MM
LEVERAGE $13.9 MM
STOCK PRICE
CURRENT
FIRM VALUE $5597 MM
LEVERAGE
~15% market
value
STOCK PRICE
RECOMMENDED
[INTRODUCTION] [ASSUMPTIONS] [RECOMMENDATIONS]
Select Financial Data After
Capital Structure Shift
FIRM VALUE $4447 MM
LEVERAGE $13.9 MM
STOCK PRICE $30/share
CURRENT
FIRM VALUE $5597 MM
LEVERAGE
~15% market
value
STOCK PRICE $39.70/share
RECOMMENDED
QUESTIONS?
T H A N K Y O U !