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