Du Pont Titanium Dioxide - Assumptions

1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985
- - - - - - - - - - - - - -
Size of Market 752 774 798 822 846 872 898 925 952 981 1010 1041 1072
Cost of New Capacity/Ton 900 927 955 983 1013 1043 1075 1107 1140 1174 1210 1246 1283
Pre-Tax Operating Expense/Ton 330 390 460 540 580 620 660 690 710 740 770 810 850
Market Share
Maintain 0.35 0.40 0.45 0.45 0.45 0.45 0.45 0.45 0.45 0.45 0.45 0.45 0.45
Growth 0.35 0.40 0.47 0.47 0.51 0.52 0.52 0.55 0.58 0.59 0.62 0.62 0.64
Average Selling Price/Ton
Maintain 555 665 760 890 955 1015 1070 1120 1170 1210 1270 1320 1370
Growth 540 640 750 880 950 1010 1070 1130 1190 1250 1310 1370 1430
Capacity
Maintain 325 340 350 360 370 381 392 404 416 428 441 455 468 482
Growth 325 350 375 400 421 443 475 505 530 552 579 616 645 685
Du Pont Titanium Dioxide - Do Nothing
Do Nothing - Stay at Existing Capacity ( 325,000 tons ) and Allow Sales to Grow Until Full Capacity is Reached
1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985
Unit Sales (1000 Tons) 263 310 325 325 325 325 325 325 325 325 325 325 325
Sales 100000 146076 205884 247000 289250 310375 329875 347750 364000 380250 393250 412750 429000 445250
Costs 86856 120744 149500 175500 188500 201500 214500 224250 230750 240500 250250 263250 276250
Pre-tax Profits 59220 85140 97500 113750 121875 128375 133250 139750 149500 152750 162500 165750 169000
Taxes 28426 40867 46800 54600 58500 61620 63960 67080 71760 73320 78000 79560 81120
After-tax Profits 30794 44273 50700 59150 63375 66755 69290 72670 77740 79430 84500 86190 87880
Plus Depreciation 0 0 0 0 0 0 0 0 0 0 0 0 0
Operating Cash Flow 30794 44273 50700 59150 63375 66755 69290 72670 77740 79430 84500 86190 87880
Less Change in NWC 9215 11962 8223 8450 4225 3900 3575 3250 3250 2600 3900 3250 3250
Less Change in FA 0 0 0 0 0 0 0 0 0 0 0 0 0
Plus Investment Tax Credit 0 0 0 0 0 0 0 0 0 0 0 0 0
Recovery
Net Working Capital 69050
Plant & Equipment 0
Total Cash Flow 21579 32311 42477 50700 59150 62855 65715 69420 74490 76830 80600 82940 153680
Du Pont Titanium Dioxide - Maintain Strategy
Maintain Strategy
1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985
Unit Sales (1000 Tons) 263 310 359 370 381 392 404 416 428 441 455 468 482
Sales 100000 146076 205884 272916 329211 363569 398286 432387 466200 501228 534155 577215 618354 660888
Costs 86856 120744 165186 199746 220806 243288 266706 287213 304164 326673 349965 379445 410040
Pre-tax Profits 59220 85140 107730 129465 142763 154998 165681 178988 197064 207482 227250 238910 250848
Taxes 28426 40867 51710 62143 68526 74399 79527 85914 94591 99591 109080 114677 120407
After-tax Profits 30794 44273 56020 67322 74237 80599 86154 93074 102473 107890 118170 124233 130441
Plus Depreciation 0 0 0 0 0 0 0 0 0 0 0 0 0
Operating Cash Flow 30794 44273 56020 67322 74237 80599 86154 93074 102473 107890 118170 124233 130441
Less Change in NWC 9215 11962 13406 11259 6871 6944 6820 6763 7006 6585 8612 8228 8507
Less Change in FA 13500 9270 9550 9830 11143 11473 12900 13284 13680 15262 16940 16198 17962
Plus Investment Tax Credit 1350 927 955 983 1114 1147 1290 1328 1368 1526 1694 1620 1796
Recovery
Net Working Capital 112178
Plant & Equipment 170992
Total Cash Flow 9429 23968 34018 47216 57336 63330 67724 74355 83156 87569 94312 101427 388938
Incremental Cash Flow -12150 -8343 -8459 -3484 -1814 475 2009 4935 8666 10739 13712 18487 235258
Du Pont Titanium Dioxide - Growth Strategy
Growth Strategy
1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985
Unit Sales (1000 Tons) 263 310 375 386 431 453 467 509 552 579 626 645 686
Sales 100000 142128 198144 281295 339979 409887 457974 499647 574888 657070 723488 820322 884225 981094
Costs 86856 120744 172528 208624 250247 281133 308194 351038 392034 428305 482174 522790 583168
Pre-tax Profits 55272 77400 108767 131356 159640 176842 191454 223850 265037 295183 338148 361435 397926
Taxes 26531 37152 52208 63051 76627 84884 91898 107448 127218 141688 162311 173489 191005
After-tax Profits 28741 40248 56559 68305 83013 91958 99556 116402 137819 153495 175837 187946 206922
Plus Depreciation 0 0 0 0 0 0 0 0 0 0 0 0 0
Operating Cash Flow 28741 40248 56559 68305 83013 91958 99556 116402 137819 153495 175837 187946 206922
Less Change in NWC 8426 11203 16630 11737 13982 9617 8335 15048 16437 13283 19367 12781 19374
Less Change in FA 22500 23175 23875 20643 22286 33376 32250 27675 25080 31698 44770 36134 51320
Plus Investment Tax Credit 2250 2318 2388 2064 2229 3338 3225 2768 2508 3170 4477 3613 5132
Recovery
Net Working Capital 176219
Plant & Equipment 394782
Total Cash Flow 66 8187 18441 37989 48974 52302 62196 76446 98811 111683 116177 142645 712361
Incremental Cash Flow -21513 -24124 -24035 -12711 -10176 -10553 -3519 7026 24321 34853 35577 59705 558681
Du Pont Titanium Dioxide - Excess Capacity
Growth Strategy
Year Excess Capacity
1973 86.80 tons
1974 65.40 tons
1975 24.94 tons
1976 34.66 tons
1977 11.54 tons
1978 21.56 tons
1979 38.04 tons
1980 18.50 tons
1981 0.00 tons
1982 0.00 tons
1983 10.00 tons
1984 0.00 tons
1985 1.00 ton
Maintain Strategy
Year Excess Capacity
1973 76.80 tons
1974 40.40 tons
1975 1.00 ton
1976 0.00 tons
1977 0.00 tons
1978 0.00 tons
1979 0.00 tons
1980 0.00 tons
1981 0.00 tons
1982 0.00 tons
1983 0.00 tons
1984 0.00 tons
1985 0.00 tons
Du Pont Titanium Dioxide - Competitive Positions
Du Pont
Operating Profit Margin = 40%
Debt/Total Capital = 9%
National Lead
Operating Profit Margin < 20%
Debt/Total Capital = 35%

NPV Profiles
NPV Profiles for Growth, Maintain, and Difference Strategies
-100000
0
100000
200000
300000
400000
500000
600000
700000
0.00 0.05 0.10 0.15 0.20 0.25
Discount Rates
N
e
t

P
r
e
s
e
n
t

V
a
l
u
e
s
Maintain
Growth
Du Pont Titanium Dioxide - Sensitivity Analysis
Variable (% of Projection) NPV (10%) Maintain NPV (10%)Growth
Base Case (100%) 62,458 140,037
Costs (140%) -616 10,217
Sales Price (75% ) -1 7,769
Market Share (87%) -1,417 61,554
NWC Recovery (0%) 49,965 108,994
Plant Recovery (0%) 36,702 80,573
NWC & Plant (0%) 24,209 49,530
NWC & Plant (0%) and
Cost of Capital (150%, or 15%/10%)
5,540 5,686
Antitrust Concerns?
Herfindahl-Hirshman Index (HHI)
The sum of the squared market shares of firms in the industry

Department of Justice (DOJ) 1984 merger guidelines
Range of HHI Category Challenge Change
Less than 1,000 Low NA
1,000 to 1,800 Moderate 100
Greater than 1,800 High 50

Unfair Competition?
Du Ponts Strategy
Build Capacity to deter Competition

Price Titanium Dioxide to Capture the Market

Restrict Licenses of its Ilmenite Process

Bond and Stock Valuation
The market value of the firm is the present value of the cash flows
generated by the firms assets:



The cash flows generated by the firms assets are divided among the
investors who pay for the assets. If these investors include only debt
and equity holders, the market value of the firm can be expressed as:

PV
firm
= PV
debt
+ PV
Stock

+
=
=
N
t
t
t
r
CF
PV
0
) 1 (
Bond (Debt) Valuation
The price of bonds in the market place is the present value
of the cash flows that bondholders have claim to:


These cash flows consist generally of two components,
interest and principal. They are generally divided as
follows:


That is, interest is paid every period, and the principal is
paid at maturity, when the bond comes due.

+
=
=
N
t
t
d
t d
d
r
CF
PV
1
,
) 1 (
N
d
N
t
t
d
d
r
P
r
I
PV
) 1 ( ) 1 ( 1 +
+

+
=
=
Bond Valuation (Continued)
Terms:
Coupon Payment: the interest paid annually, or semiannually (I).
Typically, these payments are fixed so that the interest paid each
year is the same.
Principal: the amount borrowed, and repaid at maturity (P).
Coupon Rate: the annual interest payment divided by the
principle (I/P)
Current Yield: the annual interest payment divided by the price
(I/PV)
Capital Gains Yield: the change in price (over one year) divided
by the price at the beginning of the year [(PV
1
-PV
0
)/ PV
0
]
Yield to Maturity: the return investors expect if they buy the bond
and hold it until it matures. If the market is in equilibrium, the
yield to maturity is also the return investors require given the
bonds risk (r
d
).
Bond Valuation (Continued)
Numerical Example: Suppose a bond with 10 years to maturity has a
coupon rate of 10%, a principal amount of $1,000, and a yield-to-
maturity of 10%. Assuming interest is paid annually and the bond is in
equilibrium,
What is the price of the bond?


What is its current yield?

Current Yield = I/PV =

What is its expected capital gains yield?

Capital Gains Yield = [(PV
1
-PV
0
)/ PV
0
] =
?
) 10 . 1 (
000 , 1
) 10 . 1 (
100
10
10
1
= +

=
= t
t
d
PV
Bond Valuation (Continued)
Suppose now that everything else remains constant, but the yield to
maturity is 12%. What are the price, the current yield, and the
expected capital gains yield?



Current Yield = I/PV =


Capital Gains Yield = [(PV
1
-PV
0
)/ PV
0
] =

What would cause the yield to maturity to be 12% instead of 10%?
?
) 12 . 1 (
000 , 1
) 12 . 1 (
100
10
10
1
= +

=
= t
t
d
PV
Bond Valuation (Continued)
The yield to maturity, the return investors expect, is linked to the
return investors require, r
d
.

The required return, r
d
, is a function of
The real rate of return - the return investors require for deferring
consumption (that is, the time value of money)
The expected rate of inflation - the compensation investors require to
guard against losses in their purchasing power.
The risk premium - the compensation investors require to accept the
possibility that their return will be lower than what they were promised.

If r
d
is 12%, not 10%, one or more of the three components of the
required rate of return must be higher in the second instance than in the
first.

Why is yield to maturity linked to r
d
?
Bond Valuation (Continued)
Suppose the expected rate of return does not equal the required rate of
return. If the bond above should be priced at $887 because the required
rate of return is 12%, but it is priced at $1,000 to give an expected
return of 10%, investors are not being compensated for the risk that
they bear.
The NPV from buying the bond will be negative (887-1,000), so new
investors will not buy.
The NPV from selling the bond will be positive (1,000-887), so existing
investors will want to sell.
The combination of new investors not buying and existing investors
wanting to sell will cause the price of the bond to fall.
How far? Why?
Bond Valuation (Continued)
Risk Return Relationship
0.00%
2.00%
4.00%
6.00%
8.00%
10.00%
12.00%
14.00%
16.00%
18.00%
20.00%
0.0 0.2 0.4 0.6 0.8 1.0 1.2 1.4 1.6 1.8 2.0
Risk
R
e
t
u
r
n
Bond Valuation (Continued)
Sensitivity of Bond Prices to Changing Interest Rates
0.00
50.00
100.00
150.00
200.00
250.00
300.00
4.00% 6.00% 8.00% 10.00% 12.00% 14.00% 16.00%
Yield to Maturity
P
r
i
c
e

o
f

B
o
n
d

R
e
l
a
t
i
v
e

t
o

$
1
0
0

B
e
g
i
n
n
i
n
g

P
o
i
n
t
Bond Valuation (Continued)
0
200
400
600
800
1000
1200
B
a
s
i
s

P
o
i
n
t

S
p
r
e
a
d
s
Aa2/AA A2/A Baa2/BBB Ba2/BB B2/B
S1
S4
S7
Ratings
Years to
Maturity
Spreads Between Corporate and Government Bonds
Stock Valuation
The price of stocks in the market place is the present value
of the cash flows that stockholders have claim to:



These cash flows consist generally of two components,
dividends and capital gains. They are generally divided as
follows:

+
=
=
N
t
t
s
t s
s
r
CF
PV
1
,
) 1 (
N
s
N s
N
t
t
s
t
s
r
PV
r
Div
PV
) 1 ( ) 1 (
,
1
0 ,
+
+

+
=
=
Stock Valuation (Continued)
What are the differences between bond and stock cash flows?
Interest vs Dividends
Interest is paid before dividends.
Interest is generally fixed ; dividends are variable.
Interest is a contractual obligation; dividends are discretionary.
Principal vs. Future Stock Prices
Principal is contractually binding to the firm; future stock prices are not.
In liquidation, claims to both principle and interest must be satisfied before
payments can be made to stockholders

What do these differences imply about potential differences between r
s
and r
d
?


Stock Valuation (Continued)
Risk Return Relationship
0.00%
2.00%
4.00%
6.00%
8.00%
10.00%
12.00%
14.00%
16.00%
18.00%
20.00%
0.0 0.2 0.4 0.6 0.8 1.0 1.2 1.4 1.6 1.8 2.0
Risk
R
e
t
u
r
n
Stock Valuation (Continued)
If, for simplicity, we assume that dividends grow forever at a constant
rate, g, and that that rate is lower than the required rate of return on
the stock, r
s
, then the present value of the dividends and future stock
price can be expressed as



This says that the price of the stock today equals the expected dividend
one year from today (Div
1
) divided by the difference between the
required rate of return and the constant growth rate (r
s
-g)

Under these same assumptions, the required return on the stock could
be estimated as


g r
Div
PV
s
s

=
1
0 ,
g
PV
Div
r
s
s
+ =
0 ,
1
Stock Valuation (Continued)
Suppose the expected dividend next period (D1) is $1.50, the expected
constant growth rate (g) is 8%, and the required return (r
s
)on the stock is 15%.
What is the price of the stock today

P
0
= D
1
/(r
s
-g) = $1.50/(.15-.08) = $21.43

What are the expected current (or dividend) yield and capital gains yield?
Current Yield = D
1
/P
0
= $1.50/$21.43 = .07 or 7%
Capital Gains Yield = ?

How does the stock price relate to the NPV of projects undertaken by the
firm?

Stock Valuation (Continued)
How does the stock price relate to capital budgeting decisions of the
firm? The NPV of projects undertaken by firms is reflected in stock
prices as follows



The first component, EPS
1
/r
s
, is the price of the stock if equity cash
flows (or earnings) remain constant forever. The second component is
the expected NPV from future growth opportunities.

What determines whether NPVGO is positive or negative?
NPVGO
r
EPS
PV
s
s
+ =
1
0 ,
Stock Valuation (Continued)
By setting the two stock pricing relationships equal to each other and
recognizing that (Div
1
/EPS
1
) equals 1-b, where b is the firms retention
ratio, and g is the ROE*b, we can express NPVGO as



The above relationship tells us that NPVGO will be positive so long as
the ROE on the investment exceeds the required rate of return,r
s

) ( *
) ( *
1
g r r
r ROE b
EPS NPVGO
s s
s

=
Stock Valuation (Continued)
Assumptions
ROE 20.00%
Retention Ratio 40.00%
Payout Ratio 60.00%
Required Return 15.00%
Growth 8.00%
Expected Earnings without Investment 2.50 $
Time 0 1 2 3 4 5 6 . .
Earnings with No New Investment 2.50 $ 2.50 $ 2.50 $ 2.50 $ 2.50 $ 2.50 $ 2.50 $ 2.50 $
Present Value of Earnings 16.67 $
Amount Retained (1.00) $
Additional Earnings from Investment 0.20 $ 0.20 $ 0.20 $ 0.20 $ 0.20 $ 0.20 $ 0.20 $
PV of Additional Earnings 1.33 $
NPV of Additional Earnings 0.29 $
Total Earnings 2.50 $ 2.70 $ 2.70 $ 2.70 $ 2.70 $ 2.70 $ 2.70 $ 2.70 $
Amount Retained (1.08) $
Additional Earnings from Investment 0.22 $ 0.22 $ 0.22 $ 0.22 $ 0.22 $ 0.22 $
PV of Additional Earnings 1.44 $
NPV of Additional Earnings 0.27 $
Total Earnings 2.50 $ 2.70 $ 2.92 $ 2.92 $ 2.92 $ 2.92 $ 2.92 $ 2.92 $
Amount Retained (1.17) $
Additional Earnings from Investment 0.23 $ 0.23 $ 0.23 $ 0.23 $ 0.23 $
PV of Additional Earnings 1.56 $
NPV of Additional Earnings 0.26 $
Stock Valuation (Continued)
What would happen if the firm could make these investments
indefinitely by retaining 40% of its earnings and producing ROEs of
20%?





What would the price of the stock be?

EPS1/rs + NPVGO = $2.5/.15 + $4.76 = $21.43



76 . 4 $
) 08 . 15 (. * 15 .
) 15 . 20 (. * 4 .
* 50 . 2 $
) ( *
) ( *
1
=
(

=
g r r
r ROE b
EPS NPVGO
s s
s
How does that coincide with the earlier model





How does the model we have just discussed relate to EVA, if it does?

Stock Valuation (Continued)
43 . 21 $
) 20 . * 4 . 15 (.
50 . 1 $
1
0 ,
=

=
g r
Div
PV
s
s