Dupont x5a

HISTORY 

Historically known for its policy of extreme financial conservatism.

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Low debt possible due to success in products markets. –

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High profitability allowed finance needs to be internally funded.

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One of the few AAA rated manufacturers.

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1965 – 1970 : Capacity outstripped demand leading to price falls and drop in net income by 19%.

HISTORY (cont’d)

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1970 – 1975: High inflations, rising oil prices and recession impacted the business.

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The company finally resorted to debt financing.

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1975 : $540 mn in short term debt and $340 mn in long term debt. – Debt ratio rose to 27% and interest coverage dropped to 4.6

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1979 : Debt ratio reduced to 20% and interest coverage rose to 11.5%.

CONOCO TAKEOVER

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1981 : Took over Conoco, Inc, a major oil company at a of 77% above pre-acquisition market value.

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The acquisition was debt financed and the debt ratio of Du Pont rose to 42% after the acquisition.

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Du Pont got downgraded to AA rating.

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1982 : Debt ratio was down to 36%, interest coverage was at 4.8 and the company retained its AA rating.

SCENARIO ANALYSIS Scenario 1 : Maintaining a 40% target debt ratio The Positives: 

It results in increased Return on Equity (ROE).

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Net Income and EPS also increase due increase in interest expense, which is tax deductible. This results in lower tax expense and eventually leading to greater net income. –

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The company should save approximately $ 266 million over five years from the increased tax shield due to the additional leverage.

RISK

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A major area of concern is the high risk associated with the 40% target debt ratio.

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Cost of debt will be more expensive because its bond rating will drop to A.

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Risks include the lower interest coverage and lesser access to debt funds.

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This means that the company may not be able to pay its interest on time and funds are not always available when needed.

OTHER FACTORS

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The 40% debt ratio is still below the industry average. The risks are workable because, this move might make them even more competitive in its financing.

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High tax savings result from the 40% debt ratio which will generate cash flow for DuPont.

Trade-off: Flexibility Vs Control

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DuPont is more flexible under the 25% debt ratio but will dilute present stockholders’ control over the company.

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Control is higher under 40% debt ratio but flexibility is poor.

CONCLUSION 

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The capital structure with 25% debt is optimal: 

We believe that company control should be prioritized over flexibility.

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High risk associated with the 40% target debt ratio.

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value of firm is increased in the lower debt

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Restore confidence and give the firm greater financial freedom to fund research and development and pursue new projects.