AMERICAN HOME

PRODUCTS
CORPORATION

λLAMBDA Consulting Firm

Gallegos. Marcos. Okada. Salonga.
Templonuevo.
THE COMPANY
• Has four lines of businesses
▫ prescription drugs
▫ packaged drugs
▫ food products
▫ housewares and household products

• Avoided risks in new product development and

introduction

•Tight financial control, centralizing complete

authority in the Chief Executive; “We run the business
for the shareholders.”
THE COMPANY
• In 1980, the company had almost no debt and a
cash balance equal to 40% of its net worth

• Constant growth in sales, earnings, and

dividends in recent years

• Pays out 60% of its annual earnings as dividends

• Sixfold growth in EPS pushed up value of its

stock
PROBLEM
What is the optimal
capital structure for the
American Home
Products Corporation?
REASONS FOR
CHANGING CURRENT
STRUCTURE
Additional debt may:
• Increase market price
• Yield tax shield
• Lower cost of capital
Which level of debt
will the company
adapt?
Market Value of Firm is equal to

Unlevered Value of Firm

plus

Tax Shield
minus

Distress Cost
minus

Agency Cost
Basis for Evaluation
• Interest Coverage
• Stable Sales
• Low Business Risk
• Perception of investors
• Fixed Assets
Capital Structure of Warner-Lambert
American Home Warner-
Products (@ 70% Debt) Lambert
EBIT 922.2 470
Interest 122.9
(14%)
Interest 7.5X 5.0X
Coverage
Total 2192.8 100%
70%
JUSTIFICATIONS FOR
70% DEBT
• Diversified products (low business
risk)
• High liquidity
• Gradual change will regulate distress
costs