1. Case Study
American Home Products
MTTh 6-9 PM
Dr. Dipasri Ghosh
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. 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
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
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. 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%
Cost Of Leverage Firm (COSTs) = Ku + D/E ( Ku - KD)
WACC = WD x KD ( 1 - T) + WS x Ks
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.