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Du Pont Paper Capital Structure Case

B.A. 142 CASE 2

EXECUTIVE SUMMARY

      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...

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Du Pont Case Study - Capital Structure

Du Pont Case Study 
          Capital Structure

Statement of the Problem

Determine a capital structure policy suitable for Du Pont in the 1980s and beyond.   This paper will consider the
history of the company and the turbulent times of the 1960s and 1970s, weigh the advantages and disadvantages
associated with higher and lower levels of debt, and develop a strategy for the future after the merger with Conoco
Inc. in 1983.

Executive Summary

• Du Pont has been historically known for its financial stability and low debt to equity ratio which maximized funding
flexibility and protected the business from many financial constraints.
• Competition increased in the 1970s and caused the firm to deviate from its low debt levels and its use of internally
generated monies to fund projects.
• They cut their dividend and began using debt as a source of financing.   They recognized the problems associated
with this and were able to reduce their debt levels and maintain a triple A bond ratio.
• Instead of continuing to reduce their debt to their previous levels, they decided to go in the other direction and used
more debt to acquire Conoco Inc., a major oil company, for a very high price.
• This worried investors and the increase in debt downgraded their bond rating to AA for the first time in the
company's two hundred years.
• Adopting a conservative capital structure for the future would restore confidence an d give the firm greater financial
freedom to fund research and development and pursue new projects.
• Given the current of the state of the company, going back to their conservative strategy would be very difficult to
attain and require large new equity and stock issues.
• If the company chooses to move to higher leveraged position with more debt they can take advantage of the tax
shield created and wouldn't have to issue that much more debt to continue to finance future projects.
• This increased leveraged position brings greater financial risk and less...

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Proposed Capital Structure for Du Pont Corporation

    Uploaded by settypr on Jun 7, 2006

Proposed Capital Structure for Du Pont Corporation 

The Du Pont Corporation was founded in 1802 to manufacture gunpowder. After nearly two centuries of
operations, the company has greatly diversified its product base through acquisitions and research and
development,, and is one of the largest chemical manufacturers in the world. In 1995, Du Pont had revenues of
$42.2 billion and net income of $3.3 billion. In this same period, 50 percent of the company's sales were outside
the United States. Du Pont operates in approximately 70 countries worldwide, with about 175 manufacturing and
processing facilities that include 150 chemicals and specialties plants, five petroleum refineries, and 20 natural gas
processing plants. The company has more than 60 research and development labs and customer service centers
in the United States, and more than 20 labs in 10 other countries. Currently, Du Pont is the thirteenth largest U.S.
industrial/service corporation (Fortune 500). 

Until the 1960's, the company's capital structure had historically been very conservative, with the corporation
carrying little debt (Figure 1). This was possible primarily because of the enormous success of the company.
However, in the late 1960's, competition for Du Pont had increased considerably, and the company experienced
decreased gross margins and return on capital 

Figure 1. The capital structure of the Du Pont company from 1965 to 1982. The company had very little debt as
late as 1965, but after the acquisition of Conoco, Du Pont changed to a considerably more leveraged capital
structure. 

During the 1970's, three primary variables combined to exert considerable financial pressure on Du Pont: (i) the
company embarked on a major capital spending program designed to restore its cost position, (ii) the rise in oil
prices increased costs and requirements for working capital, and (iii) the recession in 1975 had a dramatic impact
on Du Pont's fiber business. The case analyzed in this report was written in 1982, at which time the company had
a capital structure of approximately 36% debt (Figure 1). The company has ambitious research plans in the future,
which require a considerable amount of externally generated capital for 1983 through 1987 (Table 1). Therefore,
the company is seeking to develop and stick to a capital structure, which will support the company's research and
development interests in these years and the decades to come. 
Table 1. Financial Projections for 1983-1987, in millions of dollars. 

An obvious solution for the company would be to reduce or eliminate dividend payments. However, the case
states that this alternative is not possible. However, if such a action were possible, the reduction or elimination of
dividend payments would be my first choice for funding future capital expenditures. 

I believe that the best capital structure for Du Pont is to leverage itself to the point that it can comfortably cover
debt maintenance and other fixed costs. In so doing, the company will gain the maximum benefit from the resulting
tax shield. This point can be obtained by estimating cash flows in the future using projected revenues and fixed
and variable costs, as well as the additional return required by bondholders because of the increase in the
company's debt. However, another variable to take into consideration for a company like Du Pont, is financial
flexibility. Most of the company's products are a result of a capital-intensive research and development program,
and the company needs to have the financial structure allowing it to pursue positive NPV projects when the
opportunity arises. These variables suggest the company should not lever itself to the maximum level possible. 

Another objective could be to minimize the amount of taxes on all corporate income, with the firm's capital
structure solely focused on maximizing after-tax income. Personal taxes paid by bondholders and stockholders on
income from Du Pont would be included when calculating the company's total tax liability. Currently, the way the
tax system in the United States is structured, debt financing is favored. Suggesting Du Pont should finance its
future capital expenditures only by borrowing, provided the increase in interest demanded by the company's
bondholders, is less than the dollars saved from the increased tax shield provided by the debt. 

I propose that the company adopt a structure with 40% debt and 60% equity, which means a slight increase in the
proportion of debt in the company's capital structure. Earlier, the company prided itself on having a triple A bond
rating, which it had through 1980, when its capital structure had a maximum of about 25% debt. However, the
company's rating was reduced to AA in 1981, when the company borrowed additional monies, raising debt to
39.6% of its capital structure. The company's management would one again like to attain this premium bond
ranking because they feel the AAA rating is important to the company's image. However, in order to once again
achieve this rating, Du Pont will have to reduce the amount of debt in its current capital structure to at least 25%, a
reduction of at least 11% (Table 2). 

Table 2. Income, taxes and other data for two proposed capital structures for the Du Pont corporation. Data for
both a 25% and 40% debt structure are listed. 

I also have concerns about the stock market's reaction to the un-leveraging required for the company to once
again achieve this premium bond rating. Especially considering Du Pont's stock is already selling for 83% of its
value. In addition, the tax shield provided by the current amount of debt is substantial, and this shield would be
significantly lessened by reducing the company's debt back to 25% which gave the company the triple A rating. In
order to fund the ambitious capital expenditures the company plans for years 1983 through 1987, and reduce total
debt by 11%, the company would have to raise a total of $5,444,000,000 in equity issues over five years (Figure 2;
Table 2). Thus, I believe a financial policy with such a reduced proportion of debt is not in the company's and
shareholder's best interest. 
Figure 2. The total dollar value (in millions) in equity capital that Du Pont must raise in years 1983 through 1987 in
order to meet the necessary financing for planned capital expenditures and reduce total debt to 25% in the
company's capital structure. 

With a capital structure of 40% debt, the company should save approximately $ 266 million over five years from
the increased tax shield due to the additional leverage (Figure 3, Table 2). Corporations like Du Pont are ideal
companies to carry a reasonable amount of permanent debt because of the stability of the company and the large
amount of annual income the company has and can thus shield from taxes. In contrast, firms with an uncertain
future or large accumulated tax-loss carry-forwards should probably not borrow at all. 

Large, stable corporations sometimes borrow to the point until they start feeling significant financial distress from
the additional leverage. However, with a organization like Du Pont, the probability of bankruptcy is low because of
the large number of high-NPV growth opportunities inherent in a corporation whose products are based on
science. Indeed, with my proposed capital structure (40% debt and 60% equity), debt is actually profitable for the
shareholders (Figure 3). However, too much financial freedom can allow managers to over invest or indulge in an
easy and glamorous corporate lifestyle, significantly reducing company profitability. But, considering the success
of the Du Pont company, and since it had virtually no debt before as recently as 1960, significant problems for the
organization associated with too much cash seem remote. 

Figure 3. The millions of additional tax dollars saved over five years if Du Pont adapts a capital structure with 40%
debt and 60% equity. In this circumstance, with a large, stable corporation, with several NPV-growth opportunities,
debt appears to be profitable.