American Home Product Corporation

American Home Product Corporation (AHP), a highly growing American company, has four business lines: prescription drugs, packaged drugs, food products, house wares and household products. For a quite long time, AHP has applied a tight financial control and maintained an conservative capital structure policy and marketing strategy. AHP's largest and most profitable business, prescription drugs, included sizable market shares in tranquilizers and oral contraceptives; and its success in these lines of business was built on marketing expertise. William F. Laporte, is chief executive of AHP. AHP has debt-free balance sheet and growing cash reserves. Mr. Laporte had taken over as chief executive of American Home Products in 1964. Throughout 17 subsequent years of his tenure, Mr. Laporte has not changed his opinion of debt financing and AHP's abstinence from debt continued, while the growths in its cash balance outpaced impressive growth in both sales and earnings. At the end of 1980, AHP had almost no debt and a cash balance equal to 40% of its net worth.

Problem

AHP has stable and profitable financial performance, conservative capital structure and corporate culture, centralized management, excess liquidity and low leverage. AHP seemed to have no business risk and its cash balance outpaced sales and earnings at the end of 1980. AHP uses conservatism and risk aversion; it avoids risks of new product development and introduction in the volatile market. Most of its products were clever extension of existing products of competitors. It depends on marketing power to promote its acquired products and product extensions. The company was able to finance internally its growth while paying a very high portion of its earning to its shareholders.

As Mr. Laporte approaches retirement, American Home Products (AHP) has an important decision to make with respect to adopting a more aggressive capital structure policy. Analysts had speculated on the impact of a more aggressive structure policy. It is assumed that AHP will increase its debt ratio using one of the three alternative capital structures %30 %50 % 70 of debt and used the proceeds plus 233 million of excess cash to repurchase stock in 1981 at price of 30$. AHP's primary mission is to choose the appropriate capital structure that maximize profits and minimize costs, increase sales, earnings, and dividends to make money for stockholders and increase shareholder value. This paper will, analyze the impact of the implementation of a more aggressive capital structure policy: How much business risk does AHP face? How much financial risk would AHP face at each of the proposed levels of debt 30, 50 and 70 %? What is the best capital structure for AHP? What are the advantages and disadvantages of leveraging this company? What are the alternative methods for leveraging up?

Analysis

As the consumer product company, AHP has cash rich balance sheet. The company has generated sales in excess of $4 billion with growth ranging between 10%-15% annually; and gains in market share while reducing or maintaining a low level of expenses. All this combined with high dividend growth between 1972 – 1981, contributed to the firm's AAA bond rating and to the popularity of AHP's stock among others.

AHP's current financial performance is very good since it has high ROE (30.3), low debt-to-equity, good working capital ($1654.5 million) and cash excess $233 million, high profit margin, low current-to-asset ratio . All that refer to the ability of AHP to generate cash quickly; therefore it can maintain high current growth rate.