E. I. Du Pont de Nemours and Company (1983) Essay Example
E. I. Du Pont de Nemours and Company (1983) Essay Example

E. I. Du Pont de Nemours and Company (1983) Essay Example

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  • Pages: 18 (4747 words)
  • Published: November 28, 2017
  • Type: Case Study
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1. Why should a firm have a capital structure policy, i. e.

a target debt ratio? A capital structure policy aims to balance the trade-off between the benefits of debt financing (interest tax shield) and the costs of debt financing (financial distress and agency costs). Every firm should set its target capital structure such that its cost and benefits of leverage ultimately maximise the firm’s value. Graham and Harvey asked 392 firms’ chief financial officers whether they use target debt ratios. Results show that the majority of them do, although the level of strictness of the target policy varies across different companies.Only 19% of the firms avoid target ratios, of which most are likely to be the relatively smaller firms.

This clearly indicates that there must be benefits from having a target debt ratio. The trade-off theory implies


a target-adjustment model (Taggart, 1977; Jalilvand and Harris, 1984; Ozkan, 2001). In this model, firms set tentative debt ratios to which they gradually adjust. Firms with a debt ratio below the target ratio adjust their debt upward toward the target debt ratio and vice versa. The behaviour depicted is indicative that a firm can use target debt ratio as a guiding principle to follow.The target debt ratio is taken to be a reference point which enables value maximization for the firm.

The capital structure policy needs to be consistent with the firms’ funding needs, given the uncertainty of their future operating incomes. This means that a firm should employ a capital structure that provides a certain level of financial flexibility. Financial flexibility represents the ability of a firm to access and restructure its financing with low transaction

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costs. Financially flexible firms are able to avoid financial distress in the face of negative shocks, and to fund investment at low cost when profitable opportunities arise.

The importance of financial flexibility can be seen in E. I. du Pont de Nemours and company (Du Pont) case. Du Pont had a long holding low debt policy that “maximized its financial flexibility and insulated its operations from financial constraints”. As such, the presence of a target debt ratio set at a point which gives the firm its desired level of financial flexibility would benefit the firm.

2. Why did Du Pont abandon its AAA debt-rating policy? What were the consequences? What is the role of bond ratings? Du Pont abandoned its AAA debt-rating policy when it needed to finance its cquisition of Conoco which cost the firm almost $8 billion, which represents a premium of 77% above Conoco’s pre-acquisition market value. In addition, Du Pont assumed $1. 9 billion of outstanding Conoco debt. To finance the purchase, Du Pont issued $3. 9 billion in common stock and $3.

85 billion in floating rate debt. The value of its long term debt went from $1,068 in 1980 to $6,403 by the end of the following year, nearly increasing by six folds. Subsequently, the acquisition pushed Du Pont’s debt ratio to nearly 40%, from slightly over 20%, by the end of 1980.Furthermore, its interest coverage ratio went down by almost half the previous amount from 10. 9 to 5. 5.

Another reason Du Pont abandoned its AAA rating was due to the fact that the benefits accruing to the firm through the extra capital expenditure and research and development

outweighed the higher cost of debt with a lower credit rating. As such Du Pont felt that the action taken was justified despite the fact that it was fond of its AAA rating. As a consequence, Du Pont’s bond rating was downgraded to an AA rating, implying higher cost of borrowing to the company.For an example, in 1982, Du Pont had to pay an additional of 0. 38% above the rate it would have paid if it had maintained an AAA bond rating.

Although there was a marginal drop in Du Pont’s bond rating, it is generally observed that firms rated A and above have little difficulty in raising fund. Therefore, Du Pont would still be able to maintain its access to the debt market while continue its capital spending programs vital to its competitive position. The role of bond ratings is to give creditors a guideline on the riskiness of the firm.It provides an evaluation of the bond issuer’s financial strength and ability to pay back the bond’s principle and interest. The bond rating also provides investors with some sense of security when investing in a particular firm. A higher bond rating implies a lower likelihood for the firm to default.

Investors would feel more secured investing in such a bond, thus demanding a relatively lower rate of return. As such, high rated bonds enable the issuer to enjoy a lower cost of borrowing. A lower bond rating, on the other hand, serves as a negative signal to investors on the firm’s ability to repay debt obligations.Examples of bond rating agencies include Standard and Poors as well as Moodys.

According to the bond credit

ratings issued by Standard and Poors, as shown in appendix 1, bonds given an AAA rating have got an almost zero level of credit risk. Nonetheless, bonds rated A and above appear to be safe investments whereas bonds with BBB ratings and below appear as relatively riskier investments. 3. Compare and contrast the two debt policy alternatives outlined in case Exhibit 8 for 1987.

What bond rating would Du Pont receive under each alternative?How would its financial performance, financing needs, access to capital, and financial risk differ under the two alternative debt policies? 40% Debt Scenario25% Debt Scenario Debt/Total capitalization40%25. 0% Interest coverage3. 896. 17 Earnings per share$6. 62$5.

60 Dividends per share$3. 64$2. 72 Return on total capital9. 2%9. 2% Return on equity (ROE)11.

4%10. 2% New equity issues$81. 6$1271 Millions of shares sold13. 025. 2 Table 1: Projected Financial Result under Two Financial Policy Alternatives in 1987 Bond rating: Du Pont had long pursued its conservative financial policy and had achieved an AAA bond rating until 1972.

Although its debt ratio rose from 7% in 1972 to 27% in 1975 and interest coverage decreased from 38. 4 to 4. 6, the firm was able to retain its AAA bond rating during the period (due to its well maintained low debt level which allowed the firm room to take on more debt should the need arise). Under the 25% debt scenario, with an interest coverage ratio of 6.

17, Du Pont would continue to receive an AAA bond rating. As the result of the acquisition of Conoco, Du Pont’s debt ratio rose to nearly 40% in 1982 and interest coverage dropped to record low of

4. 8, yielding an AA rating for the firm.The results of these indicators are similar to those that would be observed under the 40% debt scenario. Hence, Du Pont would receive AA rating under the higher debt alternative. Financial performance: In terms of the financial performance under the two alternative debt policies, we evaluate different measures including return on equity (ROE), earning per share (EPS) and dividends per share (DPS).

From table 1, forecasted statistics indicate that performances under the 40% debt scenario outperform those under the 25% debt scenario for all indicators. With ROE of 11. %, EPS of 6. 62 and DPS of 3. 64 under the greater leverage alternative, Du Pont would achieve better financial performance and would be able to provide its shareholders with higher returns. Financial needs: Under the 40% debt scenario, Du Pont would require much less new equity financing.

New equity issues of merely $816 millions will be required under high leverage alternative, compared with a much higher amount of $1,271 millions under a more conservative approach in 1987. However, the company would require more debt financing under high leverage scenario (naturally).Access to capital: If Du Pont chooses to lower its leverage to 25% by 1986, the company would then require large equity infusions which then raise the concern of their availability. Furthermore, at year end 1982, Du Pont’s stock price had not fully recovered from Conoco’s acquisition. Hence, raising capital largely through equity would not create optimal value to the firm, considering the company’s performance and economic downturn at that time.

Furthermore, an equity issue at that time might have further punished Du Pont’s stock price. Conversely,

the 40% debt scenario eliminates the problems that equity presents.Although the firm would face a greater interest cost (cost of debt), it is generally lower than the cost of equity. Du Pont would be able to also time its future equity issue and take advantage of more favourable economic conditions later in the future, should there be any.

Financial risk: Financial risk is defined as the possibility that a bond issuer will default, by failing to repay principal and interest in a timely manner. Financial leverage and financial risk are positively related. Consequently, the 40 % debt alternative would yield Du Pont with a higher financial risk.This can also be seen by comparing interest coverage under the two scenarios.

The 40% debt alternative implies interest coverage of merely 3. 86 to the firm, while that under the 25% debt scenario implies a much higher rate of 6. 17. However, an interest coverage of 3. 86 is still relatively safe.

Additionally, when assessing the company’s default risk, bond rating proves to be a useful tool for investors. In comparison, the AAA rating under the 25% debt scenario and AA rating under the 40% scenario, clearly suggest that Du Pont would be exposed to greater financial risk, should it choose to abandon its conservatism. . What capital structure policy should the company adopt now? What issues should it consider? Du Pont should adopt the 40% debt policy alternative. Many factors, pertaining to the benefits of higher level of debt employed and the nature of Du Pont’s business and strategies, explain why the higher debt scenario is the more favourable alternative. MM proposition 1 (with taxes) states that

a firm’s value is positively related to its debt level.

This is because the interest on debt is tax deductible and the firm is able to capture the additional tax shield benefits from employing additional debt.As exhibit 8 demonstrates, by employing the 40% debt policy, Du Pont will be able to enjoy superior financial performance and its stockholders will benefit from the higher EPS, dividend per share and return on equity. This is in line with the objective of the firm to maximize its shareholders’ value. Looking at Du Pont’s nature, the company represents a technological leader which heavily invests in R&D. Du Pont heavily relies on capital spending to minimise the firm’s cost position so as to remain competitive in the industry.Therefore, the company’s large and non-deferrable financing needs present a constant source of worry for Du Pont.

As Du Pont’s stock price remains undervalued, raising funds through equity is no longer ideal. By employing additional debt in its capital structure, Du Pont will also be able to do away with its worries of having to raise such a large amount of equity at a relatively higher cost (a result of the negative response from the acquisition of Conoco), as compared to the cost of debt. This enables Du Pont to minimise the number of new shares issued at the unfavourably low price.The presence of additional debt capacity allowing for a higher debt level further insulates the company from bankruptcy risk exposure. Furthermore, an increase in the firm’s target debt ratio may serve as a positive signal to the market that the firm is expecting a high level of earnings in the years to

come. In addition, Du Pont will continue to maintain a relatively lower debt level, as compared to many of its competitors.

With reference to exhibit 3, Du Pont’s 40% Debt ratio would still be lower than those of its direct competitors including Dow chemicals and Calanese.Together with the fact that Du Pont’s earnings have been relatively stable and the fact that a bond rating of AA would still provide the company with its much desired competitive position, Du Pont can afford taking on a higher leverage. Although taking on the higher target debt ratio leaves Du Pont’s bond rating at the undesirable AA level (implying a higher cost of borrowing), Du Pont with 40% debt will still be able to maintain some financial flexibility and can continue to invest in profitable projects in the future.Thus, the benefits from adopting 40% leverage outweighs its disadvantages.

Unlike the financial industry, a drop in bond rating from AAA to AA for a firm in an industrial industry will not immensely hurt its ability to obtain funds. Moreover, firms rated A and above generally appear to have merely little difficulty in raising funds. Many companies, and perhaps too many, rely too heavily on preserving its high bond rating. In doing so, a company must make sure that this strategy does not, by default, limit its corporate growth.

Look at Du Pont’s competitor, Dow Chemical, whose total debt has frequently exceeded 50% of its total capital. Surprisingly, Dow was able to outstrip its major competitors in both terms of growth and returns on equity. Comparing with Du Pont which avoided debt until 1973, Dow’s earnings per share were growing at a

high compound annual rate and the company’s ROE finally exceeded Du Pont in 70s. In conclusion, Du Pont adopted a conservative approach in the past in order to be financially flexible so as to enable it to raise funds without difficulties in the time of need.Now that the market and economic condition have changed, Du Pont needs to remain competitive and its low-debt strategy is no longer the optimal one. Hence, the 40% debt scenario should be adopted.

5. More generally, how should a firm determine its appropriate capital structure? •Under investors’ perspectives Figure 1: Value of the firm in different levels of leverage, with presence of taxes and financial distress cost A capital structure policy that maximizes shareholder value can be achieved by maximizing firm value. A company should hus, employ a capital structure to maximize the value of the firm. As figure 1 demonstrates, for a firm with a level of debt below the optimal level (B*), the firm would be able to benefit from the tax shield advantage that taking on additional debt presents and in the process, increase the value of the firm.

At a debt level after the optimal level (B*), where the present value of distress costs and agency costs exceeds the present value of the benefits from tax shield, further increase in debt will decrease the firm’s value.This is represented by the downward sloping curve in figure 1 above. Consequently, the firm needs to find an optimal debt level where the two factors offset and the value of the firm (and shareholders) is maximised. •From the industry’s perspective Competition among firms in an industry influences the decision of

which capital structure the firm should employ.

As there is no specific formula to calculate an optimal debt level in reality, it is therefore essential for a firm to compare its debt level with other similar firms in the industry.This is to gain an insight as to whether the firm currently employs a too high, too low, or an average debt-equity ratio. It is generally expected to find that firms within a given industry adopt similar capital structures because they generally have comparable types of assets, business risk and profitability. Nonetheless, the firm must be aware of its own unique characteristics which may result in it having to adopt its own unique level of optimal debt ratio. •From an internal perspective An appropriate capital structure policy should be consistent with the firm’s future goals and expectations.Firms should not run out of cash given the firms’ plan for future growth and the firm’s current dividend policy.

In addition, firms also like to maintain some levels of financial flexibility in their capital structure. Financial flexibility enables firms to take advantage of unforeseen opportunities or to deal with unexpected events depending on their financial policies and financial structures. Fund managers can decide on the optimal capital structure using forecasts of cash flows, financial statements and the sources-and-uses-of-funds statement.Furthermore, fund managers need to also consider the volatility of the firms’ earnings. Firms with volatile earning structure should be mindful of the level of debt they adopt.

This is because interest payments on debt is a legal obligation for the firm and should its earning level decline to a level where the firm is unable to pay interest on debt,

the firm would face bankruptcy charges. The company should therefore be constantly mindful of its interest coverage ratio. 5. a Impact of leverage on the prospects and performance of the companyLeverage has both advantages and disadvantages on the prospects and performance of the company.

On one hand, the aptitude of leverage is positively related with cost of financial distress and bankruptcy, thus implying higher vulnerability for a firm to bankruptcy costs. Moreover, higher leverage implies higher risks to equity holders and in turn higher cost of equity. The cost incurred from leverage hinders the potential investment opportunities and the ability to raise external funds due to higher cost of borrowing (WACC increases when debt increases beyond the optimal level).In reality, the firm can use leverage to generate shareholders’ wealth, but if it fails to do so, the interest expense and the credit risk of default will decrease shareholders’ value. Furthermore, high levels of leverage reduce financial flexibility and thus hinder the firms’ responsiveness to unforeseen opportunities, which can in turn imply higher risks to firms.

On the other hand, leverage also magnifies gains to the firm. Because interest is tax deductible, the firm with high leverage can benefit from the tax shield and increase firm value. High leverage offers shareholders’ better returns and greater potentials.MM proposition II states that leverage increases the risk and returns to shareholders. In addition, the managers of the firm will tend to work hard when they issue debt because as they are exposed to pressure of paying back debt obligations in a timely manner. Hence, leverage can ensure the hard work of upper management and ensure the payment of interest

to the shareholders.

The free cash flow hypothesis further substantiates this theory by ensuring that the free cash flow is used to pay debt obligations instead of managers indulging in perquisites or investing in unfavourable investments. . b What problems arise from employing too much debt? Too little debt? The level of debt of a firm may affect a company positively or negatively. This depends on the level of debt the company takes on.

Generally, the ideal amount of debt is said to occur when the marginal benefit of taxes resulting from tax shield equals the marginal cost of debt. However many firms do not follow this rule of thumb as they need to evaluate other unique factors in determining its debt ratio. Too much debt Too much debt in a company may lead a company into bankruptcy.When debt is undertaken, interest payments represent fix financial costs to the firm on a periodic basis. When the promised coupon payments are not made, the bondholders are entitled to sue the company for bankruptcy.

The firm, which undertakes too much debt, increases its liability of interest payments and financial risk. If economic downturn occurs, there will be a high probability that the firm may be unable to cope with its debt obligation. High level of interest payments coupled with low returns worsen the financial distress of a firm.This is especially true in cases where the firm consist of high levels of intangible assets. When financial distress occurs, the suppliers, customers and the stakeholders are likely to demand high levels of security from the distressed firm.

In turn, the market value of the firm may decrease drastically. Too

much debt in a capital structure hinders the growth of the firm. When a firm wants to undertake debt, the cost of borrowing is determined based on the credit rating. Thus, as the level of debt in the firm increases over time, the credit rating decreases while financial risk increases, implying a higher cost of borrowing.

Although presented with a profitable and high yield projects, high cost of borrowing may deter the firm from investing as net present value of the projects decreases. Furthermore, high level of debt increases the cost of equity. Stockholders will demand a higher rate of return due to the increase of perceived risk. In extreme cases where the company is in the verge of bankruptcy, the firm may not be able to raise equity capital by issuing new shares as investors are much more risk-averse. Too little debtDebt allows a firm to enjoy the benefit of tax shields. Hence, when a firm employs too little debt, it lets go this advantage.

This decreases the value of the firm as potential tax shield transfers nonmarketable claims to marketable claims. In addition, the free cash floe hypothesis suggests that managers of a firm with high levels of free cash flow will indulge in perquisites or commit to ‘bad’ investments. However, higher debt level, which increases higher interest costs, is able to decrease these problems.Firms with low levels of debt, along with much asset, are also deemed as ‘cash cow’ companies, which are likely to be targeted of takeovers. Last, in many countries, dividends are exposed to double taxation. When a firm raises capital through equity; it is entitled to pay both corporate and

personal taxes.

On the other hand, interest payments are only taxed once at the corporate level. As such, the firm is able to minimise its loss when incorporating more debt in its structure, compared with equity, assuming the collective corporate tax and personal tax level is higher than the cost of borrowing. . c What indications does a firm have that its leverage is too high? too low? Although many other factors may be involved, firms in the same industry tend to have similar debt to equity ratio due to the similar nature of their operations. Thus, an average debt equity ratio represents a good indicator to gauge the debt structure of a firm.

A relatively higher debt equity ratio than industry average of a firm, therefore may be a signal that the firm has adopted too much debt in its structure. Alternatively, credit rating can also be used.A higher debt ratio results in lower credit rating (as financial leverage magnifies the volatility to return), which increases the perceived risk of lending to a firm. Hence, a low bond rating to a firm may be an implication of a capital structure with too much debt. Nevertheless, this is not a rule of thumb. Many factors need to be considered, including the type of industry and the firm’s strategies.

In addition to the debt equity ratio, an industry average interest coverage ratio can also be used to assess the ability of the firm to cover its debts on a comparative basis.The higher the relative debt level, the lower the firm’s interest coverage compared to that of the industry. If the firm is able to increase its

level of debt and at the same time, its WACC falls, this is an indication that the firm has a lower than optimal level of debt. This is in line with MM proposition I which states that the value of firm increases as it takes on more debt. Most importantly, we must note that there is no specific optimal amount of debt for a firm.

The firm’s debt level should be compared with similar companies in the same industry, while keeping mind of its unique characteristics.Regardless of the level of debt employed, it is important that the firm must be able to make debt payments in the future, so as to avoid the risk of going bankruptcy. The firm may adopt a higher level of debt compared to its competitors and if it faces no difficulties to finance its debts, its leverage level will not deemed to be too high. 5. d What issues relating to competitive strategy arise in the determination of capital structure policy? As a technological leader in chemicals and fibers, Du Pont grew to be the largest U.

S chemical manufacturer.The firm remained the technological leader in the industry and its success at R&D was second to none. The 1981 merger with Conoco enhanced Du Pont’s ranking to the seventh place on the list of U. S industrials. When determining the firm’s capital structure policy, the following issues should be considered in order for Du Pont to remain at its competitive position. Financial flexibility is a significant factor needed to be considered.

In Du Pont’s case, the firm’s competitive position was mainly due to its technological leadership and R&D which require

for a continued high level of investment and capital expenditure.Therefore, financial flexibility is important to Du Pont. The firm must retain its ability to raise funds for future investment opportunities without difficulties so that it can insulate its operations from financing constraints. In Addition, firms need to take into consideration the cost and availability of financing as well as its bond rating.

Companies with high debt ratios and low bond rating face greater difficulties in raising funds compared with firms rated A and above. In addition, the spread related to cost of debt between A and AAA rated firms often widens in high-interest-rate environment.It is therefore important for a firm to understand the effect of cost and availability of debt, resulting from the debt structure it employs. 5. eWhat factors are responsible for differences in debt ratios for firms in different industries? Types of assets: The cost of financial distress depends on the types of assets that a firm uses.

For example, industries with large investments in tangible assets such as properties, land, and buildings tend to have lower costs of financial distress. Thus, they have more incentives to employ higher target debt – equity ratios.In contrast, industries with intensive investments in research and development tend to have lower debt ratios as intangibles like R&D has less resale value than real estate, and most of its value tumbles in the realm of financial distress. Uncertainty of operating income: Firms with uncertain operating income are likely to experience a high probability of financial distress.

Thus, they tend to issue less debt and finance with more equity, compared with firms with less volatile earnings. For example, pharmaceutical

firms who cannot predict whether today’s research can produce new drugs often pursue low debt level.Conversely, telephone companies, which are categorized as regulated industries with low volatility of operating income, tend to take on more leverage. Growth: High growth industries are likely to have lower debt ratios than low growth ones.

The reason is that high-growth firms are able to generate internal funding from their high profitability to fuel their growth, whereas low-growth firms have to rely heavily on debt. Risk of technology: New technology firms such as software firms and internet companies which rely heavily on intangible assets use more of equity financing, compared with debt financing.For those firms, because their intangible assets can easily disappear in the case of financial distress, they face more difficulties obtaining loans, thus implying a higher cost of debt. For firms in the same industry? Taxes: Highly profitable firms are likely to have larger target debt ratios than less profitable firms as they can benefit from the tax shield that leverage provides. In addition, highly profitable firms also have better access to credit and easily obtain loans at lower cost.Firm size: Firm size has been accounted for being a determinant of differences in leverage across the board as it is closely related to risk and bankruptcy costs.

Larger firms, in general, tend to be more diversified and thus bear less risk, which helps lower their probabilities of default. They also require larger amount of debt capital than smaller firm to account for high levels of capital expenditures. In addition, firm size is positively correlated to recognition, which provides firms with higher bargaining power with creditors in order to

secure lower cost of debt.Hence, creditors are more willing to lend their funds to larger firm at a lower rate, resulting from a lower level of risk. Nonetheless, this is not a rule of thumb. Many other factors should be taken into consideration.

Appendix 1: Bond Credit Ratings Moody's Standard & Poor's Credit worthiness AaaAAATriple A = Credit risk almost zero Aa1AA+Safe investment, low risk of failure Aa2AA" Aa3AA-" A1A+Safe investment, unless unforeseen events should occur in the economy at large or in that particular field of business A2A" (Taken from http://en. wikipedia. org/wiki/Bond_credit_rating)

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