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 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 acquisition 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...