E. I. du Pont de Nemours is an American chemical company that has recently acquired the major oil company of Conoco Inc. and is becoming one of the largest chemical manufacturers in the United States. Its financial conservatism has pushed Du Pont to the forefront of the industry as its profitability soared, providing it with the liquidity to readily finance its cash needs. But several competitive conditions posed a challenge to its risk averse financial policy as the 1970's was characteristic of a declining level of industry demand and price, along with rising fuel prices and an economic recession. These pressures now force Du Pont to source its financing through debt, foregoing its risk averse capital structure policy in the past. It now aims to determine the most feasible capital structure that will enable it to finance capital expenditures vital to its competitive advantage while maintaing its financial flexibility.
Du Pont now faces two alternatives: 1) Reduce the debt/total capitalization ratio from 36% to 25% by issuing large equity instruments in the next 5 years, or 2) Maintain a 40% debt ratio, allowing it to provide higher EPS, dividends/share and return on equity.
Firstly, we calculate the cost of capital in order to determine the capital structure that maximizes the value of the firm. We then incorporate other qualitative considerations including financial flexibility, risk and consistency with DuPont's goals. Lastly, we compare each alternative's effect on EPS, its changes in company ratings and the deviations from industry standards.
The weighted average cost of capital obtained for the 40% debt alternative was 8.06% for the 5 year period, 1983-1987. Whereas, the weighted average cost of capital for the 25% debt alternative was 7.40%. Although the weighted average cost of capital is lower for the conservative option, it is important to note that these values are mere estimates and are highly responsive to changes in market trends and expectations, which greatly affect the market prices of common stock. Thus, it is crucial that other factors are considered.
Given the projections on EBIT for the next five years, the EPS for the 40% option was higher than the one for the 25% alternative for all five years. Using sensitivity analysis, it is apparent that even if the EBIT for 1987 were to be 20% below the projection, the EBIT for the 40% alternative would still be 13% higher.
Considerations for future financial flexibility were analyzed by comparing the highest projected level of indebtedness (40%) to those of competitors and also by comparing it to previous levels of indebtedness and corresponding credit ratings. It was found that the agressive 40% debt/total capitalization wouldn't be too prohibitive for the company since two of its major competitors have higher levels of indebtedness. Furthermore, when the company had a debt ratio of 40% in the passt, it was still able to maintain an a AA rating.
Thus, the 40% debt to capitalization alternative is the most appropriate capital structure because it maximizes shareholder value without compromising financial flexibility.
E. I. Du Pont de Nemours and Company, manufacturer of gun powder, and its 1970s mega-merger with Conoco, a major oil company, had led the company to abandon its long-held policy of an all-equity capital structure. Its AAA-rated bonds were backed up with its conservative use of debt combined with its profitability and technological leadership in the chemical industry. The 1960s exerted pressure on Du Pont's financial structure with competitive conditions in its fibers and plastics businesses and eventually resulted to decreases in gross margins and return on its capital. The major capital spending program designed to restore its cost position, the rapid increase in oil prices and the 1975 recession combined to intensify the...