1. American Home products corporations
American Home products corporations operating strategy is characterized by financial conservativeness as well as avoidance of risks and debt at all costs. As explained at the onset of the case study, the President, William F. Laporte explained that he did not like to owe money to anyone, and therefore preferred to use internally generated capital. This often resulted to an almost zero debt capital. He believed in risk aversion in an unpredictable business environment.
As a show of the company’s commitment to avoidance of risks, the company’s president insisted on hands on management style. Decision making had to start from the top downwards. As described by one of his colleagues, William F. Laprte was a brilliant marketer and a tight fisted spender, to the extent that even expenditure worth only $500 had to be approved by the president himself.
The president’s hand on management policy as well as a conservative approach to debts and risks is applauded for having resulted to consistent growth in the company’s fortunes for many years. This was exhibited by the growth of shareholders earnings as well as dividends per share. The company’s stocks prices soared, as a sign of confidence in the president’s able management of the company.
Analysts however, believed that the company would do much better had it employed a moderate amount of debt, instead of relying on internal sources of capital, which is considered expensive. Its with this understanding that the question below addresses the different scenarios and levels of debt, and their impact of the shareholders value.
Appropriate capital structure
In deciding the desired capital structure for the company, analysts need to explore the effects of debt on the company’s earnings. As a principle in finance, the use of moderate amount of debt is deemed beneficial to a company. This is mainly due to the benefit as a result of a tax shield since interest on debt is usually tax deductible/allowable. However, at a given level, the risk of insolvency as a result of default increases significantly, and outdoes the benefit s that would accrue from using debt capital, and at this level, the use of debt should be avoided.
Looking at the different scenarios, we have the company at zero debt as is the case at the present, then 30% leverage, 50% leverage and finally 70% leverage, as well as the different results that would be achieved at the various levels of debt. At 30%, the company’s earnings and dividends per share seem to be going up, but not as good as the company’s performance at 50%.
At 50%, the company’s performance is even better than the preceding two levels of debt. Finally, at 70%, the company seems to attain the best results and value for shareholders, however, there is a catch. At 50%, the company becomes a joint venture, meaning that the owners of the company have a similar holding as the debt providers so that company is not at risk of losing control of the company. At 70% debt however, the company has ceded control of the company, and becomes a minority shareholder. This poses the risk of insolvency, or takeover, at the will of the lenders. In a normal situation, the lenders demand for their capital would automatically lead to the insolvency of the company.
This therefore leaves 50% debt as the optimal option since at this level of debt, the company owners still have significant control of their company, while at the same time gaining maximally from the use of debt capital.
Throughout the 70’s the company engaged in a massive expansion programme that involved a acquiring a number of assets and other existing operations. The company’s strategy was to produce products in a particular region whose market could be found in those regions. As explained in the content, the company’s farm equipment was generally aligned with the sales. This meant that the company would establish a plant for the manufacture of given farm equipment where there was a huge market for the given products.
For instance, most of the production was mainly in the United Kingdom and North America, which were considered to be the strongholds in the consumption o these farm equipments. The surplus production was then exported to other parts of the world from these regions.
The use of the product market alignment suffered a lot of setback. First of all, the influx of North Sea oil strengthened the pound so much so that the product market strategy almost collapsed with the increased costs of production as a result of the strong pound, since it reduced the profit margins as well as competitiveness of the company as compared to competitors.
Currency exchange rate fluctuations was also another challenge that faced the company’s product market strategy, an example is given of an acquisition that turned out to be a loss as a result of the strong German mark.
Generally, the company tried her best to even design products for the North American market as well as European markets but all these turned out to be helpless since it coincided with a depressed economy leading to lower sales.
On the financial bit, the company employed risky levels of debt, sometimes as high as214%. This was even made worse by the fact that the company employed mainly short-term debt which is mainly quite expensive. The use of debt to finance her operations almost led to the collapse of the company, had one of the main investors not donated their shareholding to the company’s pension scheme, coupled with assistance from the Canadian government.
Troubles in 1976
As explained above, many things went wrong with the company’s expansion programme. The company’s over utilization of debt, as well as a conspiracy of various economic factors almost led to the collapse of the company. First of all, there was low demand for the company’s products as a result of various nations’ policies that led to reduced advancement of credit to farmers.
Second was a myriad of economic factors, low demand, a failed market product alignment policy, excessive debt as well as very high operating costs. The company embarked on cost reduction policies that were expected to bring the company to a profit position. These included reduction of operational costs through job cuts, selling and liquidation of unprofitable operations etc. The company also sought to reduce manufacturing space by 10,000 square feet.Competitors responded by aggressively marketing their products in most of the countries that the company operated, and this led to the loss of a significant market share for the company.
Despite efforts however did not alleviate the problem, and although the company was in a profit position in 1979, the continuing operations as well as discontinued operations were still at a loss position. The company would actually have collapsed had the Canadian government not pledged to guarantee the already defaulted loans.