Dupont Case

Dupont Case

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Executive Summary
DuPont has been known for its low reliance on borrowings. In the 1970’s, the company had to assume a substantial portion of debt of Conoco, a newly acquired company. In 1983, the managers have to decide about the future optimal target debt ratio. Should the company continue to keep about 40% of its assets financed via debt or should it strive to lower its borrowings to 25%?
We defined several criteria to determine our choice – return, risks and other quantitative and qualitative factors. Targeting a debt ratio of 40% will maximize the firm’s value. A higher earning’s per share and dividends per share will lead to a higher stock price in the future. Due to leveraging, return on equity is higher because debt is the major source of financing capital expenditures. To maintain the 40% debt ratio, no equity issues will be declared until 1985. DuPont will be financing the needed funds by debt. For 1986 onwards, minimum equity funds will be issued. It will be timed to take advantage of favorable market condition. The rest of the financing required will be acquired by issuing debt.

Case Context
DuPont is a very big company with a low debt policy designed to maximize financial flexibility and insulate operations from financial constraints. It is one of the few AAA rated manufacturing companies due its investments are primarily financed from internal sources. However, because prices fell in the 1960’s thus DuPont’s net income fell also. The adverse economic conditions in 1970’s escalated inflation: increase in oil prices increased required inventory investments of the company. 1975 recession negatively affected DuPont’s net income by 33% and returns on capital and earnings per share fell. The company cut dividends in 1974 and working capital investment removed. Proportion of debt increased from 7% in 1972 to 27% in 1975 and interest coverage falls from 38 to 4.6. The company perceived increase in debt temporary but moved quickly to reduce its debt ratio by decreasing capital expenditures. Debt proportion dropped to 20%, interest coverage increased to 11.5 by 1979.
In 1981, DuPont issued $3.9 Billion in common stocks, $3.85 billion in debt and assumed $1.9 billion of Conoco debt to acquire Conoco. DuPont debt ratio increases to 42%, interest coverage to 5.5 and ratings went down to AA.
In 1982, merger with Conoco exhibited poor performance. DuPont also lowered debt ratio to 36% due to asset sales, but interest coverage lowered to 4.

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8. To improve DuPont’s performance, substantial capital investments are planned for the future years.

Problem Definition
What capital structure policy should DuPont apply?
DuPont has been known for its low reliance on borrowings. However, in 70’s the company had to assume a substantial portion of debt. In 1983, the managers have to decide about the future optimal target debt ratio. Should the company continue to keep about 40% of its assets financed via debt or should it strive to lower its borrowings?

Alternatives
A. Maintain a 40% target debt ratio
DuPont will maintain its current capital structure policy and abandon its conservative nature. Equity issues will be much smaller and debt will be the major source for financing capital expenditures.

B. Target ratio of debt to capital of 25%
DuPont will lower its capital structure policy to 25% by adding large equity infusions. It will restore the conservative nature of the company and reduce debt financing.

Decision Framework
1. Analyze the relevant ratios from present financial statement
2. Compare and contrast projected financial results under 25% and 40% financial policy alternatives.
3. Set criteria for determining the better alternative.
4. Choose!
Analysis
We begin our analysis by analyzing the position of DuPont at the current period. This will provide us insights on the effect of the current capital structure policy which is a debt ratio of 40%. Prior to 1980s, DuPont has been well known for its policy of extreme financial conservatism. The company’s low debt ratio was feasible in part because of its success in its product market. In fact, this made them one of the few companies with an AAA rating that allowed it to maximize financial flexibility. We can divide the previous period by the time with conservative debt policy (1965-1979) and that with a more liberal debt policy (1980).
Year Sales* EBIT* Capital Expenditure*
1965 $ 2,999 $ 767 $ 327
1966 $ 3,159 $ 727 $ 531
1967 $ 3,079 $ 574 $ 454
1968 $ 3,455 $ 764 $ 332
1969 $ 3,632 $ 709 $ 391
1970 $ 3,618 $ 590 $ 471
1971 $ 3,848 $ 644 $ 454
1972 $ 4,366 $ 768 $ 522
1973 $ 5,964 $ 1,100 $ 727
1974 $ 6,910 $ 733 $ 1,008
1975 $ 7,222 $ 574 $ 1,036
1976 $ 8,361 $ 961 $ 876
1977 $ 9,435 $ 1,141 $ 704
1978 $ 10,584 $ 1,470 $ 714
1979 $ 12,572 $ 1,646 $ 864
Growth Rate 11.15% 9.03% 9.90%
* In thousands dollars ($ ‘000)

From above, we see that sales grew at an average of 11.15% and EBIT at 9.03%. Coinciding this, is an average capital expenditure of 9.90%. Let us now look at the second period.

Year Sales* EBIT* Capital Expenditure*
1980 $ 13,652 $ 1,209 $ 1,297
1981 $ 22,810 $ 2,631 $ 2,389
1982 $ 33,331 $ 3,545 $ 3,195
Growth Rate 56.60% 76.18% 58.97%

We can see a soaring increase on the growth of sales and EBIT for this period, 56.60% and 76.18% respectively. This may be because due to liberal debt financing policy, they are able to acquire more capital to help boost up sales. Evidently, capital expenditure grew to 58.97% after applying the liberal debt policy which helped DuPont expand sales.
Selected Data 1982
ROE 8.20%
Beta-coefficient 2.6956
Average stock price $ 37.19

Despite the increase in financial leveraging, ROE declined in the prior periods. We also computed the DuPont stock’s beta-coefficient which equals 2.6956. This means that the firm’s stock experiences extreme volatility than the market. In fact, the firm’s average stock price has been in a historical low of $37.19.
Debt has an important effect on a firm’s financial performance as well as on a firm’s policy. Debt offers tax shields since interest income is tax deductible. Since DuPont plans to substantially increase its capital expenditure by using external funds, it needs assured access to external capital markets that have the ability to raise the necessary amount at low costs. A stable debt policy will allow DuPont to maintain its ratings, rates and access to the market even during periods of adversity.

Debt Ratio 25% 40%
Interest coverage 6.17 3.86
Interest payments $ 705,000,000 $ 1,126,000,000
Annual tax shield (tax=40%) $ 282,000,000 $ 450,000,000

Given the two alternative debt ratios, we first compare their annual interest coverage. The debt ratio of 25% has interest coverage of 6.17 in the year 1987 while the debt ratio of 40% has interest coverage of 3.86. The lower interest coverage, the more the company is burdened by debt expense since lower interest coverage means that the company’s ability to meet interest expenses is relatively weaker. Say for example, at 40% debt ratio, the interest coverage is only 3.86. This means that interest expense will only be met by multiplying 3.86 to the firm’s net income. This is relatively smaller compared to the 6.17 interest coverage given a 25% debt ratio. There is, however, one advantage of having a high debt ratio: higher tax shields. Given the data above, a 40% debt ratio will yield a 59% higher tax shield than that of having a 25% debt ratio. Why is this important? This is important because tax shields increase income after tax, which increases the overall value of the firm.
Debt Ratio 25% 40%
EPS $5.60 $6.62
Stock Price at P/E = 10 $56.00 $66.20
Change in EPS with 20% lower EBIT -24% -27%
DPS $2.72 $3.64
ROE 10.2% 11.4%
EPS/ROE $54.90 $58.07

Earnings per share (EPS) is generally considered to be the single most important variable in determining a share's price. EPS is higher under the 40% debt ratio; consequently stock price is higher at 40% debt ratio. But if Earnings before interest and taxes (EBIT) drops 20%, the decline in EPS is greater in the 40% debt ratio as seen above. On the other hand, dividends per share (DPS) is 34% higher under the 40% debt ratio as compared to the 25% debt ratio. This means that stockholders get a higher share in dividend income given a 40% debt ratio. In terms of profitability, a 40% debt ratio has a higher return on equity (ROE) of 11.4% as compared to the 10.2% ROE in 25% debt ratio. This shows that DuPont generates higher profit with the money shareholders have invested given a 40% debt ratio as compared to a 25% debt ratio.
Lower debt ratio will result to higher bond rating. 25% debt ratio may bring back the company’s AAA bond rating or it may remain in the present AA bond rating. On the other hand if the company continues the present 40% debt ratio, bond rating may fall to A to BBB. This will cause the company higher interest rate for future issues of bonds since the lower the bond rating, the riskier the issues become therefore leading to a higher interest rate.
Under the 25% debt ratio, future debt needs are smaller and future equity needs are larger. Availability of equities is the major concern under this alternative. Under 40% debt ratio, equity issues will be much smaller and debt will be the major source for financing capital expenditures. Therefore, finding a low rated debt will be the main concern for the company.
There is a trade-off between flexibility and control under the two alternatives. DuPont is more flexible under the 25% debt ratio but will dilute present stockholders’ control over the company. Control is higher under 40% debt ratio but flexibility is poor.
Overall, we see that risk is lower under the 25% debt ratio and higher in 40%debt ratio. But the return is greater in the 40% debt ratio. It will be a matter of deciding which outweighs which.

Recommendation
We recommend that DuPont Corporation should target a debt ratio of 40%.

Justification
A major area of concern is the high risk associated with the 40% target debt ratio. Cost of debt will be more expensive because its bond rating will drop to A. Risks include the lower interest coverage and lesser access to debt funds. This means the company may not be able to pay its interest on time and funds are not always available when needed. However, the 40% debt ratio is still below the industry average. The risks are workable because in fact, this move will make them even more competitive in its financing. Moreover, company control will not be diluted under the 40% debt ratio. If DuPont attempts to reduce debt ratio to 25%, large equity issues will be needed that poses significant concerns for present stockholders. Thus, the 40% debt ratio is still on the interest of the company.
There is a trade-off between flexibility and control under the two alternatives. DuPont is more flexible under the 25% debt ratio but will dilute present stockholders’ control over the company. Control is higher under 40% debt ratio but flexibility is poor. We believe that company control should be prioritized over flexibility. Lastly, a high tax savings result from the 40% debt ratio which will generate cash flow for DuPont.

Implementation
Given our choice, DuPont will apply a more liberal capital structure policy by maintaining its 40% debt ratio. Massive capital expenditure will be made in the future periods that will result to an increasing need for external financing. The net financing requirement is summarized below:
Year Net Financing Requirement
1983 $ 338
1984 $ 626
1985 $ 1,246
1986 $ 1,712
1987 $ 1,886

To maintain the 40% debt ratio, no equity issues will be declared until 1985. DuPont will be financing the needed funds by debt. In doing this, DuPont shall establish a sound partnership with a trusted investment bank and create the most favorable terms of agreement for these debts. The relationship with this bank will be for long-term to minimize transaction costs. For 1986 onwards, minimum equity funds will be issued. It will be timed to take advantage of favorable market condition. The rest of the financing required will be acquired by issuing debt.
To address the market’s negative reaction to the liberal debt policy, there needs to be an open communication with the shareholders of DuPont. In the shareholder’s meeting, the plan for maintaining the present capital structure policy will be reported emphasizing on the benefits of increasing earnings per share and meeting capital expenditure financing to expand sales. Hopefully, DuPont stock will recover from its historical down.
DuPont must also take action in showing transparency in terms of paying its creditors. This will assure that debt funds will be there when needed by the company in order to maintain its capital structure policy of having 40% debt.
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