American Home Products

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American Home Products
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A Theory of Capital Structure

• Think of the cash flows that the firm could
  possibly make without taxes or other costs and
  making all the right decisions. Let this be the
  size of the pie.
• Debt
• Equity
• Taxes
• Bankruptcy Costs
• Agency Costs

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A Theory of Capital Structure

• With real world influences taken into account the
  MM theory still says capital structure choice
  simply cuts up the pie.
• The difference now is that there are marketed
  (debt and equity) and non-marketed (taxes,
  agency, and bankruptcy costs) claims. The
  objective is to maximize the former and minimize
  the latter.
• The value of the levered firm can be thought of
  as
• VL VU (present value of tax shields)
• - (present value of bankruptcy costs)
• - (present value of agency costs)

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The Value of the Firm with Costs of Financial
Distress
Value of firm (V)
VL VU TC B Value of firm under
MM with corporate Maximum taxes and
debt firm value V Actual value of
firm VU Value of firm with no debt
Debt (B) B Optimal
amount of debt The tax shield increases the value
of the levered firm. Financial distress costs
lower the value of the levered firm. The two
offsetting factors produce an optimal amount of
debt.
Present value of financial distress costs
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Establishing a Capital Structure

• Lessons From The Data (What Do We See)
• Most companies have low debt/equity ratios (lt1)
• Changes in financial leverage affect firm value
• Increases in leverage increase firm value
• Decreases in leverage decrease firm value
• Consistent with tax shield
• Capital structure varies by industry
• Steel Industry 1.7 D/E
• Pharmaceutical 0.08 D/E
• Firms with a high proportion of assets in
  intangible assets and growth opportunities use
  little debt.
• It appears that each industry has a target
  debt/equity ratio.

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Choosing an Amount of Debt

• The theory provides no clear formula (unlike NPV)
  but the tradeoffs are clear the benefits versus
  the costs of debt.
• A safe strategy might be to emulate the industry
  average. After all these are the firms who have
  survived. From there you make alterations as your
  own situation dictates.

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American Home Products

• Learning Objectives

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AHP Learning Objectives

• To illustrate the impact of different capital
  structures on a firm's financial performance and
  the valuation effects of debt.
• To illustrate the textbook concepts of capital
  structure theory and the choice of a target debt
  ratio.

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AHP Facts

• Current Situation.
• Book Debt 13.9 Million
• Book Equity (Net Worth) 1472.8 Million
• B/(BS) 13.9/(13.91472.8) 0.009
• Virtually no debt in capital structure.
• Current share price 30
• Current shares outstanding 155.5 Million

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AHP Facts

• Very stable cash flows.
• Proposal to use 233 Million in excess cash and
  some debt to repurchase shares.
• Could they increase shareholder value by adding
  debt?

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Effects of Cash Repurchase
Shares Outstanding After Repo
155.5-(1472.8-1239.8)/30 147.7
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Warner Lambert

• Warner Lambert is a similar company to AHP and of
  similar size.
• Warner Lambert has a book debt to total capital
  ratio B/(BS) of 32 and an AAA/AA debt rating.
• What if AHP adopted a capital structure of 30
  debt?
• If B/(BS)0.3, then B0.3(Total Capital)

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Effects of a 30 Debt to Total Capital Ratio
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AHP

• How much would share price potentially increase
  with this new capital structure?
• Assume that AHP will maintain 30 B/(BS)
  indefinitely
• Value of tax shield on debt is TD
• 0.48(376.11) 180.5 Million
• 180.5/135.7 1.33 per share

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AHP

• How safe is AHPs debt at a 30 debt to total
  capital ratio?
• Interest rate is assumed to be 14
• Interest Expense 0.14(376.11) 52.65
• Interest Coverage EBIT/Interest
• 922.22/52.65 17.5
• Warner Lambert Interest Coverage 5

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AHP
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AHP
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AHP Learning Objectives

• To explore the impact of corporate culture in
  which the capital structure decision is
  embedded--how to persuade management to implement
  an optimal debt ratio.
• To consider the usefulness of the textbook notion
  of optimal debt when management has the
  discretion to choose any debt policy it wishes
  (however inefficient in the eyes of textbook
  finance).