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Choice of the Optimal Capital
Structure
By ab
Case Facts
• Company has almost debt-
free balance sheet and
growing cash reserves(40% of
net worth in 1981)
• Over 1500 heavily marketed
brands in four lines of
business : prescription drugs,
packaged drugs, food
products, houseware &
household products
• More than $4 billion sales in
1981
AHP’s Corporate
Culture
Continued……
•Conservative capital structire :
Excess liquidity and low degree
of leverage

•Primary mission is to make


money for its stockholders and
to maximise profits by
minimising costs

•Increased sales, earnings, and


dividends for 29 consecutive
Continued……
•Steady growth : 10% to 15%
annually
•ROE : 25% in 1960 to 30% in
1980

•Financing growth internally


while paying out 60% of annual
earning as dividends

•Price-earning ratio has fallen


Capital Structure
Policy
•Three alternative capital
structures to achieve higher
debt ratio
30% debt
50% debt
70% debt
•Assumption : AHP issued debt and
used the proceeds plus &233
million of excess cash to
repurchase stock in early 1981 at
the then prevailing stock price of
Our Recommendation
• Optimal capital structure
should be 70% debt of total
capital

• Basis of selection:
shareholder value
maximization

• Complies with the


company’s mission of
Pros of the Recommended
Debt Ratio
Maximize Shareholder’s
Value
• It has been the company’s
mission to give maximum
profits to its shareholders
• At 70% debt, the EPS and
DPS are maximum as
shown
• Additionally, higher EPS and
DPS imply an possible
increase in stock price
which is beneficial to the
EPS and DPS for
Different Capital
Additional Benefits of a
Higher Debt Ratio
• Return on Equity also increases
significantly with increase in
Debt ratio
• This implies increase in
shareholders, value
Continued…..
• The PBT reduces due to the
interest expense of the
additional debt

• As a result, there is a
significant reduction in the
taxable income thereby
reducing the corporate
taxes
Disadvantages of the
Recommendation
Risk Analysis
• Business risk:

Company has low


business risk due to
conservative approach
towards R&D and the ‘me-
too’ approach towards
introduction of new
products
Continued……
• Financial Risk:
Due to a higher debt
ratio, its financial risk would
increase significantly
It may be degraded in the
bond rating due to
increased exposure to risk
thereby increasing the cost
of debt
Conclusion
Conclusion
• Looking at the company’s
mission of increasing
shareholders’ value, it
should adopt the 70% debt
capital structure

• We also recommend that the


company should continue its
strict expenditure control
Thank You!