E.I.

du Pont de Nemours and Company (1983)

FINC303 Case Report

Claire Philipsen 4779047 Richard Haworth 198663 Guillaume Kesse 2491552 Anthony Ruddenklau 1703425 James MacIntosh 674690

Contents Page
Executive Summary...................................................................................................................................3 Introduction...............................................................................................................................................4 History........................................................................................................................................................4 Reasons for a Capital Structure Policy...................................................................................................5 Advantages and Disadvantages of Debt Financing................................................................................6 Tax Benefits.....................................................................................................................................6 Bankruptcy Costs............................................................................................................................6 Agency Costs...................................................................................................................................6 Loss of Flexibility...........................................................................................................................6 Discipline of Management..............................................................................................................7 Competitive Strategy.................................................................................................................................7 Impact of Leverage on the Prospects and Performance of a Company...............................................7 Indications that a Firms Leverage is Too High or Too Low.................................................................8 Abandonment of AAA Bond Rating........................................................................................................8 Comparison of the two Debt Policy Alternatives (25% Debt and 40% Debt).....................................9 Bond Rating.................................................................................................................................... 9 Financial Performance.................................................................................................................. 9 Financial Needs and Access to Capital....................................................................................... 10 Financial Risk.............................................................................................................................. 11 Sensitivity Analysis between Good and Bad Economic Conditions............................................. 12 Quantitative and Qualitative Analysis of the Two Alternatives........................................................ 12 Cost of Capital Approach............................................................................................................. 12 Adjusted Present Value Approach............................................................................................... 12 Comparables Approach........................................................................................................... 13

Conclusion................................................................................................................................................13 Appendices...............................................................................................................................................14 Endnotes...................................................................................................................................................19

Executive Summary This report analyses the capital structure decision facing management of E.I du Pont de Nemours and Company during the early 1980s. Du Pont is a leading American chemical manufacturer, ranked seventh on the list of U.S. Industrials. This report will specifically analyse both the qualitative and quantitative factors surrounding Du Ponts capital structure policy, financial position and strategies as they stood at the beginning of 1983.

The two decades preceding 1983 were ones of major change for Du Pont. These changes had implications on the operations and capital structure of Du Pont and forced the firm to abandon their long-held policy of maintaining an all-equity structure, losing their AAA debt rating in the process. This policy had previously been maintainable due to the ability of the firm to finance its needs through internally generated funds, thus ensuring maximum financial flexibility was upheld.

The focus of this report will be on determining an optimal capital structure for Du Pont under the current conditions. We will look at why it is important that Du Pont does in fact have a target debt ratio, before looking more generally at the impact that leverage has on the prospects and performance of a company, problems and implications of employing too much debt and issues relating to competitive strategy that arise when determining a capital structure policy. Specifically, this report aims to ultimately determine whether the firm should pursue a 25% or 40% debt ratio in the current economic environment.

After analysing the benefits and costs associated with each scenario, this report recommends that it would be in Du Ponts best interests to employ a 40% debt ratio. This alternative brings Du Pont more in line with the industry whilst minimising the cost of capital and still allowing the firm to maintain its competitive position.

Introduction E.I. Du Pont de Nemours and Company is a leading chemical manufacturer in the United States. This report analyses issues that management faced in 1983 regarding the capital structure policies of the firm. Changes in the economic environment had lead to an abandonment of Du Ponts historical all-equity capital structure. This report will cover a general overview as to the reasons why it is important a firm adopts a capital structure policy; advantages and disadvantages of debt financing; how debt affects the competitive strategy of the firm; consequences that arise from employing too much or too little debt; and how the firms bond rating may be affected by the level of debt. Several different approaches will then be covered in order to compare both qualitatively and quantitatively a 25% debt policy alternative with a 40% debt policy alternative, before reaching a conclusion as to which alternative is in Du Ponts best interests to adopt.

History (For a detailed timeline see Appendix 1) Du Pont was founded in the United States in 1802 by a French man named Eleuthre Irne du Pont. The firm was originally a gunpowder mill and by 1811 had become the countrys largest gunpowder manufacturer. Early in the 20th century Du Pont diversified into other areas through research and acquisitions and it grew to become the largest U.S. chemical manufacturer and a technological leader in chemicals and fibres. Du Pont prided itself on its no debt policy and between 1956 and 1970 they had negative financial leverage, since their cash balance exceeded total debt. By 1972 they had no short term debt outstanding, a debt ratio of only 7%, interest coverage of 38.4 and an AAA rating. By 1981, Du Pont had experienced an oil shock as well as a recession which had a dramatic impact on their fibre business. During the recession net income fell by 33% and return on capital and earnings per share all fell. In an effort to diversify and control some of the suppliers of their core business efforts, Du Pont completed a vertical integration merger with a major oil supplier named Conoco. This sent a significant signal to the market that their no debt policy was over, as they took on $1.9 billion of 4

outstanding Conoco debt. The acquisition propelled Du Ponts debt ratio to nearly 40% from slightly over 20% at the end of 1980. The challenge now is for Du Pont to decide on an appropriate capital structure for the future and effectively signal this to the market.

Reasons for a Capital Structure Policy The optimal capital structure should incorporate the amount of debt that the firm is able to hold without compromising its competitive position. This requires a rather subjective analysis by management in order to balance the costs and benefits associated with debt. Du Ponts historical financial conservatism was feasible largely due to the companys high profitability and therefore ability to finance its needs through internally generated funds. The rapid increase in oil prices, their major capital spending program in response to competitive pressures, the recession of 1975, and then the acquisition of Conoco in 1981 were all major factors in Du Ponts abandonment of the all-equity policy. There is evidence that firms tend to follow a hierarchy when financing. This is commonly referred to as the Pecking Order Hypothesis. Internal funds are the most preferred choice, as this allows for the greatest financial flexibility. This is followed by debt and then equity. Internally generated funds are no longer sufficient for Du Pont to meet increasing expenditures. Therefore the next best alternative is to take on more debt. The determined debt/equity ratio is an essential tool that can be used as a guide for management when determining the amount and type of funds to raise in the future to finance overall operations and growth. Management should attempt to maintain the target ratio at any point in time and if the actual proportion of debt falls below the established level new funds should be raised to increase it. Debt can be issued in the form of bond issues or long-term notes payable. Correspondingly, if the actual proportion of debt is above the target level then stock may be sold. As well as being a useful tool for management, a target debt ratio also communicates information about the future capital structure of the firm to stakeholders, which essentially acts as a signal of the health and performance of the company.

Advantages and disadvantages of debt financing According to the trade-off theory, in order to maximise firm value Du Pont should increase their leverage until the tax savings resulting from an increase in debt are just offset by financial distress costs. Tax Benefits Adding debt to the financial structure introduces an interest tax shield since debt is tax deductable. This means debt will be more advantageous the higher the effective tax rate and firms that have substantial tax shields are less likely to use debt. On the other hand firms with higher tax rates will invest in more debt. There is a wide range in tax rates among different industries. Bankruptcy Costs As firms borrow more they increase their expected bankruptcy costs. The probability of bankruptcy depends on the certainty of the future cash flows of a firm. Industries that have volatile and uncertain cash flows will have a higher probability of going bankrupt. These firms will tend to have lower debt ratios, although firms that have insurances or bailouts from external entities such as the government will tend to borrow more debt. Agency Costs Agency costs arise when a firm hires a manager with interests that deviate from the stockholders. This clash of interests can lead to managers investing in riskier projects than stockholders would want them to or to managers paying themselves benefits such as large dividends. The greater a firms agency costs the less debt the firm can afford to use. Firms whose investments can be easily monitored and observed will have less agency costs. The agency cost associated with monitoring actions and second guessing investment decisions will be larger for firms with long term projects. Loss of Flexibility When making financial decisions firms need to take into account the capacity to take on projects in the future. If a firm borrows to its maximum capacity it may lose the opportunity to finance future projects with debt. The more uncertain a firm is about its future investments, the

greater the value of preserving flexibility. Firms with high growth opportunities should maintain low levels of debt. Discipline of Management Debt also adds discipline to management. The attitude of management is a factor to be taken into account, as more aggressive managers may be more inclined to use debt in an effort to boost profits.

Competitive Strategy The chemical industry is a large and competitive one and capital expenditure is important in order to maintain their competitive position within the industry. In 1983, Du Pont was the largest chemical manufacturer in the United States and they experienced much success in research and development. These continuously high levels of investment and capital expenditure mean that the cost and availability of financing as well as financial flexibility is important to Du Pont. Their historical all-equity capital structure allowed for maximum financial flexibility which was important as it ensured the firms competitive position was not interfered with. An increase in debt would reduce this flexibility, so it is important they maintain their ability to raise funds without any issues or their competitive position will suffer.

Impact of Leverage on the Prospects and Performance of a Company Leverage generally has the effect of increasing the performance of a company as it nears its optimal capital structure, where firm value is maximised. When a firm is below its optimal debt level it will be undervalued and be at risk of a hostile takeover. Also at low levels of debt management may become complacent and invest poorly. By taking on more debt the firm can eliminate much of the takeover risk, add discipline to management, and take on more projects and thus increase its future prospects without diluting company ownership. However with more debt, the firm is more at risk to earnings volatility as interest payments will increase and have to be paid regardless of increases or decreases in operating income. This then increases the default risk of the firm. Because of this, firms with volatile earnings should take on less 7

debt. Operating leverage refers to the division between fixed and variable costs. Firms with greater amounts of variable as opposed to fixed costs will be less sensitive to business conditions. This is because in economic downturns these firms can reduce costs as output falls in response to falling sales.i Du Pont has a high level of operating leverage and is affected greatly in bad economic conditions. This is best shown during the 1975 recession, where net income fell by 33%, while their return on total capital and earnings per share fell by more than 50%. Leverage increases profits when the company is doing well, but magnifies losses when the company has poor results. Thus, financial leverage increases the equity holder return risk, which in turn raises the expected return on equity. This higher discount rate will offset the higher expected earnings overall.

Indications that a Firms Leverage is too High/too Low An indication that the leverage is at the right level for a company can be found by identifying its stage in the life cycle. Essentially, during the growth life cycle of a firm, the level of debt tends to vary. (e.g. start-up funding needs v mature company). Others indications come from the copmanys own characteristics, such as volatility of earnings, protection from the government, liquidity of assets and differences within the industry. All of these characteristics determine the ability of firms to raise debt. In fact, empirical evidence demonstrated that the debt ratio is lower for firms with more volatility when the operating income and R&D expenses increase.ii The right level of debt can also change depending on the strategy and the managers priorities. Sometimes management may prefer to hold less debt in its capital structure for reasons such as reducing the agency problem or just preference. Barclay, Smith and Wattsiii support this idea with the conclusion that investment opportunities are one of the most important determinants of a firms debt ratio.

Abandonment of AAA bond rating The acquisition of Conoco in 1981 drove Du Ponts Debt ratio to nearly 40% and their debt rating was downgraded from AAA to AA. To finance this large acquisition, Du Pont issued $3.9 billion in common stock and $3.85 billion in floating-rate debt. The market reacted poorly to the 8

acquisition and their share price tumbled. Although Du Pont planned to reduce debt throughout 1982 with the sale of $2 billion in coal and oil, at the time there was a major shortage in coal assets, which depressed energy prices and hampered Du Ponts debt reducing plans. By the end of 1982 Du Ponts Debt ratio hit a peak of 42% and the poor economic conditions held interest coverage at a near record low of 4.8. Prior reputation meant Du Pont was able to retain its AA bond rating. The role of bond ratings is to assess the credit worthiness of corporation or government debt issues. These ratings are an indicator to potential investors of debt securities as to how likely the corporation or government is of defaulting. The ratings are assigned by agencies such as Moodys, Standard & Poors, and Fitch Ratings. Firms with lower ratings are somewhat more susceptible to the adverse effects of changes in circumstances and economic conditions than firms in higher-rated categories. The higher a firms bond rating the lower the cost of debt. This low cost of debt makes it more affordable for firms to issue debt.

Comparison of the two Debt Policy Alternatives (25% debt and 40% debt) Bond rating Based on the data from the case we can estimate the synthetic bond rating of Du Pont for each debt policy alternative during 1987 under both normal and bad economic conditions. The comparable firm we have used to determine the ratings is Industrial Corporation, because even though both Electric Utilities and Telephone Companies are more stable over a longer period of time, they maintain a high rating despite aggressive use of debt. Du Ponts financial leverage differs from its competitors and is less volatile than other industrial firms. This allows the company to maintain a higher bond rating in general. The 25% debt policy would have an AA Bond rating and the 40% debt policy a BBB bond rating. Financial performance Du Ponts earnings per share (EPS) is increased due to the amplified firm value obtained through the tax shield benefit associated with the raised debt. At 25%, Du Pont has obviously not reached its optimal debt ratio. Dividends per share (DPS) also increase by $0.92, from $2.72 to $3.64. With the 25% and 40% debt scenarios, return on capital (ROC) stays constant at 9.2% but 9

return on equity (ROE) increases from 10.2% to 11.4% respectively. The increase in earnings is reflected in the share price as the price to earnings ratio stays constant at 10 (Appendix 2). However, the assumption that the P/E ratio remains constant when calculating the share price is not realistic as the P/E ratio will fall when debt is increased from 25% to 40%. This is because the firm will appear more risky to investors. For this reason our estimated share price at the 40% debt ratio is overstated. If the share price does not change as debt increases this means that the P/E ratio has decreased by 1.54 to 8.46. However, we believe that due to the under-utilization of debt and the size and safety of Du Pont, the P/E ratio will not fall proportionally and will settle around a figure of 9, meaning that there will be an overall increase in the value of the firm. Financial Needs and Access to Capital There are a multitude of factors that can limit a firms access to capital. These include stakeholders preferences, the firms ability to afford the different alternatives and the consequences described by the 'signalling theory of debt'. In Du Ponts case the two most preferable capital financing options (retained earnings and debt) are more accessible at the 25% debt ratio. At this alternative, internally generated funds are $3.2 billion in 1987 (Appendix 4). The increase in business risk due to the impacts on Du Ponts competitive position and higher volatility leans toward keeping a relatively conservative capital structure. However, Du Pont would have to issue large amounts of stock due to the fact that the stock price has not yet recovered from the recession and the markets negative reaction to the Conoco acquisition: $1,271 million, where 25.2 million shares are sold. By dividing the amount by the number of shares sold we calculate that the shares would have cost, on average, $50.44 each. This is an expensive way of financing. Furthermore, with regards to the signalling theory of debt, management communicates with its investors and the market through the use of leverage. When a firm does not use the most preferred capital raising method as described in the 'pecking order hypothesis', it generally indicates to investors that the firm no longer has the ability to raise funds by these methods, and so sends a negative signal to investors. Nevertheless, companies with high rating bonds, A and above, seem to raise debt more easily for a lower cost than the lower rated bonds and that could help to maintain better financial flexibility. 10

At the 40% debt ratio, internally generated funds are expected to be $2.09 billion in 1987. Under this debt policy, no equity issues seem to have been required before 1986 which would allow Du Pont to take advantage of better market conditions by issuing less stock than projected earlier in the low-debt policy: $816 million (decrease of 35.7%) for 13 million shares sold. The cost of the shares would be $62.77 on average. This is beneficial as an increase in debt financing does not dilute the ownership of the firm. Another advantage is the higher tax shield which increases the value of the company and thus the stockholders wealth through the EPS. Du Ponts interest coverage ratio decreases from 6.17 to 3.86 as the debt ratio increases with associated interests payments and decreasing income. This reduction in flexibility may hinder Du Pont in the future as well as reduce its bond rating. Financial Risk Globally, Du Pont will be faced with more costs at the 40% debt ratio than at the 25% debt ratio. The agency problem will be greater at the 40% level because of conflict of interests between bondholders and shareholders. Management may be more likely invest in more risky projects at higher levels of debt because of the incentive to invest in high return projects. Du Pont will have higher bankruptcy costs because it will have a higher probability of default, with the probability being about 2.3% compared with a probability of 0.23% at the 25% debt ratio (Appendix 6). The direct costs of bankruptcy should be the same regardless of the capital structure; we also expect indirect costs to be roughly the same under each capital structure. These costs, based on the loss of business and reputation Du Pont would suffer, are expected to be high since it has a reputation for ultra conservatism. We estimated the indirect costs to be around 20-25% of firm value and direct costs to be about 5-10% of firm value. The expected bankruptcy costs at the 40% debt ratio is roughly $76 million whereas the expected bankruptcy costs are only $9 million at a 25% debt ratio. Du Pont will lose much of its financial flexibility by moving to a debt ratio of 40%. If the market was to crash and Du Ponts earnings fell drastically, management would have less of an ability to respond to these challenges at the 40% debt level. Moreover, the risk of a hostile takeover is greater at the lower debt ratio because the firm is undervalued. 11

Sensitivity Analysis between Good and Bad Economical Conditions In the case of a scenario of bad economical conditions, we can observe that impacts on company profitability are bigger in the high-debt policy. Therefore this policy could be seen as riskier if future economic conditions are uncertain. This is exasperated downwards further to 3.09 when the scenario includes an EBIT that is 20% lower in 1987.

Quantitative and Qualitative Analysis of Alternatives Cost of Capital Approach The calculations and assumptions for Du Pont are based upon the 1982 figures. These are the most relevant since any figures before this did not include the full effect of the acquisition of Conoco. We found that the 40% debt ratio had the lower weighted cost of capital (WACC), with it being 12.58% compared with 13.03% at the 25% debt ratio. Therefore the 40% debt ratio is the preferable capital structure using the cost of capital approach. Because the WACC is lower at the 40% alternative, it means that Du Pont will identify more projects as having a positive NPV. Adjusted Present Value Approach Under the APV approach the firm value including the effects of the tax shield and bankruptcy costs show that the value will be $4532.39 billion at the 40% debt ratio and $3616.79 billion at the 25% debt ratio. This means that under this analysis the preferable capital structure option is to implement the 40% debt ratio because it maximises the firm value and therefore maximises capital gains for shareholders. Comparables Approach After the Conoco acquisition, the debt ratio of Du Pont in 1982 of 37.5% is similar to its competitors. Indeed, the financial data in Exhibit 3 from the case shows us that Du Pont de Nemours shares more or less similar characteristics. Other factors which suggest keeping the debt ratio around 40% include the fact that Du Pont is the largest chemical manufacturer and technological leader in the industry, costs are reduced in all business segments by capital spending projects, and cumulated volatility is reduced with the Conoco merger. This stronger position within the industry effectively 12

allows Du Pont to borrow more money and keep a high debt ratio policy while staying in line with the rest of the industry. All of these methods analysed lead to the agreement that the best option for Du Pont to take is to implement a 40% debt policy, as this is overall the most beneficial to the firm.

Conclusion The ultimate issue facing Du Pont is whether to pursue a 25% debt policy or a 40% debt policy. After analysis of the costs and benefits associated with each alternative, we are able to make a recommendation as to the best capital structure policy to employ. Going with the 25% debt option means that Du Pont would have to issue equity shares and this would signal to the market that Du Pont is in a poor financial position. Du Pont can avoid this since they have the capacity to issue larger amounts of debt. Although the 25% option may potentially have a higher bond rating we feel the cost of negative feedback from the market is larger than gains from a higher bond rating. Since rating agencies do not rate firms on numbers alone, the bond rating may not necessarily be downgraded since Du Ponts previous conservative debt policy has built trust between the firm and the market. We therefore recommend the 40% debt policy as it sends better signals to the market, has a lower cost of capital and better aligns Du Pont with the rest of the industry.

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Appendices Appendix: 1 Timeline for E.I du Pont de Nemours and Company (1802 1987)
1802 1900 1965 1970 Early 1970s 1972 E.I. du Pont de Nemours and Company (Du Pont) founded. Du Pont had begun to expand rapidly through research and acquisitions. Negative Financial leverage between these years, since Du Ponts cash balance exceeded its total debt. Substantial price declines resulted in net income falling by 19%. Du Pont embarked on a major capital spending program.

No short-term debt outstanding Debt ratio of 7%. Interest Coverage of 38.4. AAA bond rating. The rapid increase in the price of oil pushed up Du Ponts feedstock costs increased required inventory investment, while oil shortages disrupted production. Du Pont experienced the full impact of the oil shock; its revenues rose by 16% and costs jumped by 30%, causing net profit to fall by 31%. The escalation of inflation ballooned the cost of the capital spending program to more than 50% over budget. Du Pont floated a $350 million 30-year bond issue and a $150 million issue of 7-year notes. Recession had a dramatic impact on their fibre business. Between the 2nd quarter of 1974 and the 2nd quarter of 1975 fibre shipments dropped by 50% on a volume basis. Net income fell by 33%. Between 1973 and 1975, Du Ponts net income, return on total capital, and earnings per share all fell by more than 50%. Du Pont responded to the financial shortfall by cutting its dividend in 1974 and 1975 and slashing working capital investment. The firms short-term debt rose to $540 million by the end of 1975. Debt ratio rose to 27%. Interest coverage fell to 4.6. Du Pont retained its AAA bond rating during this period. Between 1976 and 1979, financing pressures eased. Capital expenditure declined from their 1975 peak as the spending program initiated in the early 1970s neared completion. Net income more than tripled during this period, helped by relatively moderate energy price increases and the economy wide recovery from the 1974-1975 recession. Du Pont reduced the dollar value of its total debt in 1977, 1978 and 1979. By the end of 1979, Du Ponts debt had been pared to about 20% of total capital. Interest coverage had rebounded to 11.5 from 4.6 in 1975. Du Pont was again well within its AAA bond rating. At the end of 1980, the firm ranked 15th on the Fortune 500 list of U.S. industrials. In August Du Pont succeeded in buying Conoco Inc. for $8 billion. The acquisition was the largest in U.S. history and represented a 77% premium above Conocos pre-acquisition market value. Both Du Ponts stock price and industry analysts responded negatively to the acquisition. To finance the purchase, Du Pont issued $3.9 billion in common stock and $3.85 billion in floating-rate debt. Du Pont assumed $1.9 billion of outstanding Conoco debt.

1973

1974

1975

1975 1979

1980 1981

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The acquisition propelled Du Ponts debt ratio to to nearly 40% from slightly over 20% at the end of 1980. The rapid escalation in financial leverage had cost Du Pont its cherished AAA bond rating. Du Ponts bond rating was downgraded to AA. The acquisition elevated Du Pont to 7th place on the list of U.S. industrials. Du Ponts ratio of debt to total capital had peaked at 42% - the highest in the firms history. Conocos first year (post-acquisition) performance was hampered by declining oil prices, while an economic recession plagued the chemical industry. Although Du Ponts 1982 revenues were 2.5 times 1979 sales, 1982 net income fell below 1979 results; return on capital was cut in half during this period, and earnings per share fell by 40%. To reduce interest rate exposure, Du Pont refunded most of the firms floating-rate debt with fixed rate, long-term debt issues. Plans to reduce debt with the proceeds from the sale of $2 billion in Conoco coal and oil assets were frustrated by depressed energy prices. By the end of 1982, Du Pont had paired its debt ratio to 36% from the post-merger peak of 42%. Poor earning this year held interest coverage down to a near record low of 4.8. The firm retained its AA bond rating. Even with a recovery in gross margins, strong sales growth, and successful sales of Conoco assets, Du Pont would be forced to seek external financing each year from 1983 to 1987. The major reason was the need for a continued high level of capital expenditures.

1982

1983 1987

Appendix: 2 Share Price with 25% Debt Scenario & 40% Debt Scenario
40% Debt Scenario Earnings per Share ($) Share Price 25% Debt Scenario Earnings per Share ($) Share Price 4.13 41.30 4.77 47.70 5.41 54.10 5.46 54.60 5.60 56.00 4.27 42.70 1983 4.20 42.00 1984 4.98 49.80 1985 6.02 60.20 1986 6.31 63.10 1987 6.62 66.20 1987 with 20% lower EBIT 4.83 48.30

The share price is defined as Earnings per share * P/E ratio Assume a price-earnings ratio of 10 (As stated in exhibit 8 of the Du Pont case).

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Appendix: 3 No. of Shares

1982 40.00% 16871/ 37.19 =453.64 25.00% 453.64

1983 0

1984 0

1985 0

1986 11.7

1987 13

Total 478.34

9.5

14.3

28.8

36.2

25.2

567.64

Numbers are given in millions of shares.

Appendix: 4 Internally Generated Funds

40% =478.34*6.62 =$3166.61

25% =567.64*5.6 =$3178.78

For the share price used a P/E ratio of 10

Appendix: 5 Cost of Capital Approach

Assumptions; Tax rate = 46% = 5.5% Bankruptcy Costs = 30% of firm value At the 25% will be rated AA, and at 40% will be rated BBB L = 0.5714 U = 0.44 rf = 11.91% (the commercial paper rate).

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25% L Ke Kd WACC 0.52 14.76% 7.84% 13.03%

40% 0.6 15.2% 8.64% 12.58%

Appendix: 6 Adjusted Present Value Approach

25% Scenario Sales EBIT EBI Depreciatio n Cap. Exp. Change WC FCFF PV FCFF NPV FCFF Interest Tax Shield PV Tax Shield NPV Tax Shield NPV Expected Bankruptcy Costs Firm Value Interest Coverage

1982 33331 3545 894

1983 36664.1 4189.62 2262.39 2101 2767 973 623.39 623.39 2531.99

1984 40330.51 5184.15 2799.44 2111 3386 414 1110.44 982.41 506.85 206.27

1985 44363.56 5728.26 3093.26 2212 4039 594 672.26 526.17 576.8 207.67

1986 48799.92 5532.27 2987.43 2396 4202 587 594.43 411.61 640.65 204.06

1987 53679.91 4872.34 2631.07 2667 4667 650 -18.93 -11.6 880.18 248.03

739 339.94

478.23 219.98 219.98 1086.02 1.21

3616.79 3.91 4.6 5.57 6.23 6.17 4.94

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40% Scenario Sales EBIT EBI Depreciatio n Cap. Exp. Change WC FCFF PV FCFF NPV FCFF Interest Tax Shield PV Tax Shield NPV Tax Shield NPV Expected Bankruptcy Costs Firm Value Interest Coverage

1982 33331 3545 894

1983 36664.1 3925.49 2119.76 2101 2767 973 480.76 480.76 2988.85

1984 40330.51 4704.6 2540.49 2111 3386 414 851.49 756.36 727.61 334.7 297.31

1985 44363.56 5637.65 3044.33 2212 4039 594 623.33 491.83 909.73 418.48 330.19

1986 48799.92 6153.36 3322.82 2396 4202 587 929.82 651.69 1016.14 467.43 327.61

1987 53679.91 6716.5 3626.91 2667 4667 650 976.91 608.21 1126.44 518.16 322.6

739 339.94

599.41 275.73 275.73 1553.44 9.9

4532.39 3.91 3.67 3.88 3.95 3.89 3.86

25% Scenario Total Capital Debt Ratio Debt Level Interest Coverage EBIT

1982 16871 35.70% 6021 3.91 3545

1983 18558.1 33.80% 6272.64 4.6 4189.62

1984 20413.91 31.40% 6409.97 5.57 5184.15

1985 22455.3 28.20% 6332.39 6.23 5728.26

1986 24700 25.00% 6175.21 6.17 5532.27

1987 27170 25.00% 6792.73 4.94 4872.34

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40% Scenario Total Capital Debt Ratio Debt Level Interest Coverage EBIT

1982 16871 35.70% 6021 3.91

1983 18558.1 36.00% 6680.1 3.67 3925.49

1984 20413.91 37.10% 7573.56 3.88 4704.6

1985 22455.3 39.70% 8914.75 3.95 5637.65

1986 24700 40.00% 9880.33 3.89 6153.36

1987 27170 40.00% 10868.37 3.86 6716.5

Sales and Capital are assumed to grow at 10% p.a. Probability of Default is assumed to be 2.3% at 40% debt, and 0.28% at 25% debt. Bankruptcy Costs are estimated to be 30% of firm value The cost of debt is 14.52% at 25% debt, and 16.01% at 40% debt WACC is 13.03% at 25% debt, and 12.58% at 40% debt Tax Rate = 46% Net working capital equals 13% of sales Net fixed assets equal 40% of sales, depreciation is 15% of fixed assets in the previous year.

Endnotes
i

Bodie, Z., Kane, A., & Marcus, A.J. (2011). Macroeconomic and Industry Analysis. In, Investments (9th ed.) (pp. 548

582). New York: McGraw-Hill Irwin.

ii

Bradley, M. Jarrell, G., & Kim, E.H. (1984). On the existence of an Optimal Capital Structure: Theory and Evidence.

Journal of Finance, 39, 857 878. Barclay J., Smith W. Clifford, Watts L. Ross (1995), The determinants of corporate leverage and dividend policies, journal of Applied Corporate Finance, Vol. 7; N4; p. 4-19
iii

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