American Home Products Corporation Case

The American Home Products is a products corporation which has almost 1500
market brands and sales of $4 billion (1981) with growing cash reserves of 40% of
its net worth.
It primarily deals in four lines of business:
-

prescription drugs
Packaged drugs
Food products
Housewares and household products

It has been ranked last in 21 drug companies in corporate communication. It

exercises a tight financial spending monitoring.
It follows the principle of risk aversion ie it does not believe in spending a lot in R&D
but mostly rely on licensing. It has a centralized authoritarian aspect with all
managerial decision taken by CEO Mr. Laporte.
The major issue concerning the new CEO would be about capital structure. Should
the company go for debt or continue without any debt.
The new CEO would need to decide should the amount of leveraging will be 30%,
50% or 70% provided it should attain two things:
-

Maximize shareholder value

Should restrict any rise in cost of financial distress and provide benefit of taxshield.

Options evaluation:
1) Even after paying 60% dividend, Operations can be fully financed with profit.
2) Risk is very low as almost nothing is spent on R&D.
3) Even after 50% leverage, interest coverage ratio is almost double ie 10.5

Also, there are certain risks in this option. Even though the company is profitable,
there are barriers as patents and brands. Having said that American Home products
is fairly diversified company with no investment in R&D. And as it has rigid financial
control policy, it enhances credibility.

Debt Ratio

Actual (.9%)

30%

50%

70%

Earning Per
share
Dividend Per
Share
Book Value
Interest
Coverage
P/E Ratio
Dividend
Yield
PV of Tax
Saving

$3.18

3.33

3.41

3.49

$1.90

2.00

2.04

2.1

9.47
415.6

6.47
17.5

4.92
10.5

3.16
7.5

9.43
6.3%

9.01
6.7%

8.80
6.8%

8.60
7.0%

285.69

406.03

526.41

Tax Change

-37.8

-54.7

-71.5

Ratings:

Ratings
Debt Ratio
Interest Coverage

AAA
17
%
18.2
5

AA
24
%
8.5
7

A
30
%
6.5
6

BBB
39
%
3.8
2

BB
48
%
3.2
7

B
59
%
1.7
6

Ie for American home products

-

AAA 30% leverage

AAA or AA 50% leverage
AA or A 70% leverage

Therefore, even if company goes for 30% debt, it will still be AAA rated or at most
AA rating.
It establishes company as risk free. Also at 30% leverage, purchase amount of
$595.2 million would provide a tax shield of almost $40 million.
If it goes for 50% debt, it would not increase cost of financial distress significantly.
But, depending on the currently capital structure, its advisiable to go for 30% debt
and increase it to 50%.
About 70% debt, it should be avoided as going for it wont result in much stock
value appreciation, but negatively, it may result in increase in cost of financial
distress. Also additionally, it would further degrade the rating to B or below. It would
result in negative sentiments in market.

Continental Carries, Inc

Continental Carries, Inc, a regulated general commodities motor carrier, who has
shipping routes along the pacific coast and other parts of Midwest. To expand its
operations, they were looking to acquire midland freight, inc and were evaluating
the way to finance the acquisition. Midland Freight, Inc would cost $50 million in
cash and would result in $8.4 million in earnings before interest and tax for CCI. The
possible three options being evaluated are:
1) Issuing new common stock
2) Issuing preferred stock
3) Selling bonds.

Ms. Thorp, is trying to evaluate the impact of issuing bond and of issuing stock on
Earnings per share. The risks in accepting any of the options is being evaluated. The
bond alternative arranges to sell $50 million in bonds to a insurance company in
California with the interest rate of 10%. And maturity of 15yrs. The sinking funds
required are $2.5 million, ie it leaves $12.5 million outstanding at the time of
maturity. The issuing of this time is termed as a long-term-debt and can result in
slowed or stunted growth of company. The company needs to payback the loan
amount within stipulated time and in addition needs to pay the interest over the
debt. It also puts additional risk for stockholders and management who are primary
stock holders, because due to some reasons if the company earnings are much
lower than what was forecasted by the company. The resultant would put
bondholders in riding seat and would virtually give companys control to them.

The second alternative of issuing common stock of 3 mil shares at $17.75 /share.
This would result in common stock to stand at 4.5 million outstanding shares. If
accepted, it would raise many concerns for CCI. The introduction of new shares
would create resentment in present shareholders as it would dilute the stock and
bring down the overall value in terms of earnings per share. If there are too many
shareholders, then the overall increased earnings will need to be shared with all (old
as well as new shareholders). This would create more dependency on shareholders,
which ultimately results in less flexibility for the company.