American Home Products Corporation

The case provides an excellent vehicle for exploring and challenging the notion of optimal capital structure in theory and practice.

American Home Products is a very successful firm which, according to traditional financial theory, pursues an extremely inefficient capital structure.

AHP has no debt in its capital structure.

Because of its efficiency in asset management and its high level of profitability, AHP does not need debt to finance its operations.

Financial Risk

The risk associated with moderate levels of debt (e.g., 30%) is very low. Sensitivity analysis of EBIT implies financial leverage is not very risky.

Interest coverage is twice Warner-Lambert’s even at 50% debt.

Moreover, AHP can pay down debt quickly with internal funds if it so wishes. Thus, the capital structure change is easily reversible.

This is an enormously profitable company with numerous entry barriers (e.g., brands, patents).

AHP is a stable company: Its stability in sales and earnings (see case Exhibit 1) are explained by the fact that it is a large company, well diversified in terms of business, products (1500+), and customers.

In addition, the company has the operating policy which is designed to avoid risks in R&D and new product introductions.

Management’s tight operating control and monitoring also reduce risk.

However, the percentage gain in stock price from additional debt is minuscule. TN-1 illustrates that the absolute aggregate gain in equity value is material, but the percentage increase in equity value is tiny.

Reason:

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