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...
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