American Home Products (AHP) has established a strong track record of revenue growth and return on equity over the past decade, producing a host of products in four separate business lines: prescription drugs, packaged drugs, food products, and housewares/household products. AHP’s distinctive culture emphasizes conservatism, cost control and risk aversion.
AHP’s corporate structure also concentrated most decision-making authority with the incumbent chief executive, William F. Laporte.This approach and the results that followed has led to popularity amongst investors, with Laporte had stating that “a corporation’s primary mission is to make money for its stockholders and maximize profits by minimizing costs. ” In line with the corporate culture, AHP capital structure was very conservative.
With total debt of $13. 9 million against Firm Value of 4. 6 billion, debt to value ratio is negligible. AHP may be following the pecking order theory, meeting all investment needs with internally generated funds.
One can however question whether or not AHP is indeed minimizing their costs since a more leveraged capital structure could potentially create substantial tax savings. We therefore examine what those savings could be for such an approach, as well as the potential risks involved. Key Assumptions Several foundational assumptions were necessary to determine financing economics. We used 13. 9% as the risk-free rate based on the 14% AAA rated yield less 0. 1% assumed AAA premium to the risk-free rate, and an 8% market risk premium.We calculated require return rate of equity based on the stock price, dividend and growth rate. We then used CAPM approach to derive the Beta.
To determine the likely bond ratings we considered both the interest rate coverage ratio (EBIT/Interest) and D/V ratios. We then applied yield spreads using linear interpolation. Financial distress exists when internally generated funds do not suffice to meet all cash flow obligations; we felt the interest coverage ratio is the most important indicator approximating the likelihood of this condition. We used 20% of equity value as the cost of financial distress.
For measuring leverage, the case gave us book values as found on the balance sheet. The debt to equity can also be calculated using market values. The market value of debt is usually more difficult to obtain directly, since very few firms have all their debt in the form of bonds outstanding trading in the market. Using market value is more realistic as it takes into account prevailing conditions, which are relevant for the marginal decision.
Since however that information is not available, we took the approach of assuming book value of debt is equal to market value. Even though the case mentioned that repurchases of stock at $30 per share and that interest rate is 14%, we know that as debt to equity ratio changes these figures will also change. As debt increases, interest rate will also rise, as investors require higher returns for increased risks. The share buyback should also boost earnings per share with should lead to an increased price.
Approach To evaluate the economics of increased leverage, determined two key numbers in the spirit of the Adjusted Present Value (APV) technique: the present value of the tax savings generated, and the cost of financial distress caused by the increased risk of default. We calculated the present value of the tax-shield is calculated using the formula: tax rate ? BV of Debt, assuming that the discount rate and the debt’s interest rates are equal. For the risk of default, we determined the debt rating that would likely result from each D/V ratio based on the resulting interest coverage, then utilized historical data to estimate the probability of default. Although these calculations provide a quantitative estimate of the effects of increased leverage, there are still several qualitative factors to consider, as will be discussed below.
Results Detailed calculations can be found in Exhibit 1 for D/V ratios (book basis) from 10% to 100%.Although we used book D/V as the label for each option (consistent with the case text), our debt rating/risk of default calculations were done using market D/V as described above. Using a tax rate of 48% tax rate and an assumption that the price will remain at $30, for different debt to value ratios, we can see that the present value of the tax shield increases as we increase debt, with interest rates also slowing increasing and the WACC slowly decreasing.The tax shield benefit must be compared to the costs of financial distress.
Cost of financial distress was calculated using the formula: Exp. cost of FD=prob. of FD ? cost of FD of default where FD is financial distress. We also assumed the interest rate charged would increase as debt rose to reflect the increased risk.
With the yield premium on AAA and BBB debt as endpoints, we used linear interpolation to estimate the yield premium at the intermediate bond ratings.We also used bond ratings to estimate the probability of default using historical data. Our calculations yielded the following: The costs of financial distress are very low even when we extend the horizon out to 10 years. On the basis of these numbers (and making a few key assumptions such as a fixed share price), we would conclude that AHP can increase firm value through increased leverage.
Observations and Concluding CommentsThe numbers suggest the AHP benefits from levering up – under the trade-off theory of capital structure, the tax savings far outweigh the cost of (possible) financial distress. To put it a different way, AHP can take some value away from the US government and distribute instead to investors in the form of interest payments (new debt holders), monetized shares (shareholders who sell their shares during the buyback), and higher per-share dividends (shareholders who hold their shares). There are however several other risks not easily quantified.First, the pharmaceutical industry is characterized by high risk and volatility due to limited product life cycles (‘patent cliffs’), as well as potential recall/lawsuit costs – as an example, Merck suffered losses equal to approximately half of its then-current annual revenue during its recall of the drug Vioxx.
We do note that AHP’s business model, focused on line extensions, acquisitions and licensing of already developed products, is likely less risky that that of a more research oriented drug company.Their diversification in home products also provides some cushion as well. However, the pecking order theory would also lend itself to the idea of remaining unleveraged – if one can fund ongoing investment with current earnings, why take the time and trouble to issue debt? Issuing debt could also potentially send a negative message to the markets (that AHP thinks it will need debt to fund investment because earnings will not be sufficient).Conversely, a massive share buyback could cause the opposite effect, with the potential increase in earnings per share being factored into the price – our flat price assumption would then be invalid and more debt would be necessary to generate the same shrinkage in shares outstanding.
Because of these issues, we do not recommend that AHP dramatically increase its leverage, though the numbers might suggest there is value ot be had by so doing.We think that AHP can take advantage of the benefits of leverage up to a point where they can still maintain a AA rating. This point is at 70% book D/V or approximately 20% market D/V. In order to manage market reaction, we would recommend announcement of a share buyback program specifically noting its role as a cost saving approach, then implemented gradually.
Through this approach, AHP can monitor the market to ensure that the assumptions held for determining the value of leverage are indeed holding.
