AHP Case
American Home Products (AHP), a major competitor in the worldwide pharmaceutical industry, sells over 1,500 heavily marketed brands in four lines of business. In 1981 AHP enjoyed sales in excess of four billion dollars and has had major success in growing the business every year since 1972. ... Shareholder Value at AHP In opposition of Modigliani and Miller’s Proposition, which can be interpreted that an optimal capital structure does not exist and that a company’s capital structure is irrelevant; modern finance theory suggests that a firm should have the goal to maximize shareholder’s wealth; and is enabled to do so through appropriate allocation of its capital structure. ... With Laporte’s tenure about to end, there were many questions as to what direction AHP should follow in terms of capital structure. ... AHP’s present investment strategy (1981) allocates minimal dollars to R&D or new product development because of its firmly rooted conservatism and aversion to risk. Most of AHP’s new products are either acquired or licensed after they were developed by other firms, or are “add-ons” to products already on the market. AHP’s strategy has been to capitalize on its marketing expertise and focus efforts on selling, resulting in the erosion of competition’s market share. One competitor refers to AHP as ‘selling the hell of everything they’ve got’. This short-term investment strategy has worked very well for AHP historically, but we will explore if the implementation of a more aggressive long-term capital structure might further enhance shareholder value. ... Between 1977 and 1981, AHP’s LVI equaled 74.8 (Exhibit 1), which implies that about 25% of AHP’s common stock was attributable to dividends over the next 5 years, and expected future cash flows contribute to 75% of the stock’s value. If a more aggressive capital structure, replacing some equity financing with debt, was chosen, this would potentially boost investor confidence in AHP’s future cash flows and cause the LVI to increase. ... In 1981, AHP paid dividends on stock at $1. ... For example, AHP’s current cost of equity (1981) is about 10. ... The interest expense associated with debt financing is a tax-deductible expense to AHP. ... During William Laporte’s rein as CEO, AHP’s stock has been widely held by major institutional investors. ... Thus, in addition to considering the savings of debt in evaluation of optimal investment strategies, one must also take into consideration AHP’s reputation as a well-run stable company to the value of the firm. ... Risk Levels at AHP It is important to look at how much risk AHP has faced historically, and what the result would be of taking on more risk in the future. With an extremely risk-averse CEO running the firm, AHP shows signs of very little business or financial risk. ... By creating ‘me too’ products through acquisition, or licensing from other vendors within the industry, AHP is alleviated from the business risk associated with high investment in plant, equipment, and technology for new product developments. For example, if any prescription drugs are unsuccessful or fail to be approved by the FDA, the company who developed the drug is affected, not AHP. Being well diversified also keeps AHP away from business risk. Although AHP’s largest business is prescription drugs, they sell over 1,500 well-known brands in four lines of business. Not being dependant on a single source for income makes AHP less risky for investors. In addition, AHP participates in areas of the market that would probably not be highly affected by a recession. ... Because AHP is relatively un-levered today (1981), business risk is really the primary factor that would affect potential shareholders. Since AHP finances almost entirely with equity, the only risk facing shareholders is the 10. ... If AHP were only in the prescription drug business, they would be at much higher risk, because the drug industry in general could be considered high-risk. ... 9% today, AHP faces minimal financial risk. ... At AHP’s current level of debt, the default risk premium is close to zero because there is virtually no difference between the cost of equity of the levered firm and the un-levered firm.