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E.I.

Du Pont de Nemours and Company


Memo

E.I. Du Pont de Nemours and Company


DATE: January 27, 1983
TO: Mr. Edward Jefferson, Chief Executive Officer
FROM: Mr. Anil Sikka, Chief Financial Officer
SUBJECT: Future Capital Structure of the company

Please find appended below a report regarding the future capital structure of the company. An
analysis and evaluation of the potential options for adoption of a suitable new structure has
been included. A final recommendation and corresponding action plan are also provided at the
end.

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Executive Summary
The conservative financial policy that Du Pont followed is no longer possible due to change in
new market dynamics. To maintain its competitive position, it is essential that company pursues
increased capital spending programs. As such, a choice has to be made between two capital
structures (25% or 40% Debt to Capital ratio). Taking into consideration the impact on financial
flexibility, future bond ratings, competitive position, the risks and company’s profit sharing, it
is recommended that company should move forward with 25% debt to capital ratio.

(Word Count: 86)

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Table of Contents

Memo ....................................................................................................................................................... i
Executive Summary ................................................................................................................................ ii
Table of Contents ................................................................................................................................... iii
Situational Analysis ................................................................................................................................ 1
Problem Statement .................................................................................................................................. 1
Options .................................................................................................................................................... 1
Criteria for Evaluation ............................................................................................................................ 2
Evaluation of Options ............................................................................................................................. 2
Recommendation .................................................................................................................................... 3
Action Plan.............................................................................................................................................. 3
Exhibits: .................................................................................................................................................. 4

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Situational Analysis
The increase in Du Pont’s debt to total capital ratio to 42% for acquisition for Conoco, Inc.
lead to losing its AAA bond rating as the acquisition was made at 77% above its pre-acquisition
market value. This was the second time that the company deviated from its conservative capital
policy. The performance of Conoco has been affected by declining oil prices in 1982. Also, the
economic recession in the same year has hit the whole chemical industry. The company has
been given AA bond rating owing to the quick appreciation in financial leverage.
The last two decades had witnessed the increased volatility in the company’s basic businesses.
The company’s profitability and competitive position has deteriorated in many product lines.
Excess industry capacity and the higher economies of scale led to reduced gross margin. Hence
it is critical to minimize the company’s cost position in existing products through consistent
capital spending.
In view of the importance and magnitude of Du Pont’s projected financing needs, it is necessary
to analyse the effect of cost and availability of debt on its ability to pursue capital spending
programs.
There are two financing alternatives for Du Pont to fulfil its large financing needs
1. Target ratio of debt to capital 25%
2. Maintaining 40% of target debt ratio
Reducing the debt ratio from 36% in 1982 to 25% by the end of 1986 would require large
equity issues but Du Pont’s lower stock price would make it difficult for required new equity
financing. However, higher debt policy (40%) would require relatively lower or no equity
issues. 25% debt ratio would help Du Pont maintain its AA rating which will help the company
to raise funds easily reducing the risk.
Higher debt ratio could substantially degrade the bond rating to as low as BBB making it
difficult for Du Pont to finance debt at the lower cost which can pose critical risk to its capital
spending programme.

Problem Statement
What should be the targeted Future Debt Capitalization ratio for company’s capital structure
policy?

Options
1. 25% Debt-Capitalization Ratio
2. 40% Debt-Capitalization Ratio

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Criteria for Evaluation
1. Impact on Financial Flexibility: The low debt policy maximized flexibility and
insulated operations from any financial constraints. This ensures protection from
market fluctuations and has to the highest priority.

2. Impact on Bond Rating Medians: Capital expenditure is required to maintain cost


leadership. As bond rating contributes significantly to minimizing debt financing, this
has to be the second priority. Higher rating reduces the cost of borrowing. Interest
Coverage and Total debt to capitalization ratio are used for rating the firm.

3. Impact on Competitive Strategy: Profitability indicators like EPS and ROE is


proportional to Debt to Capitalization and should be the next priority as this contributed
to having a competitive position thorough scale economies.

4. Impact on Risk: Volatility of Du Pont has increased in last twenty years. Intense
Competition had pressured prices and profits of the Du Pont. A higher debt could put
Du Pont more prone to risk.

5. Impact on Profit Sharing: Lower Debt to Capital will result into higher issuance of
Equity hence, profit sharing will be high. This has to be given the final priority.

Evaluation of Options

1. 25% Debt-Capitalization Ratio

 Impact on Financial Flexibility Achieving Zero Debt Capitalization ratio is not


feasible, therefore target 25% Debt to Capital will be sufficient to provide higher
degree of flexibility and protection from market conditions.
 Impact on Bond Rating Medians: Du Pont will able to achieve 25% debt to capital
in four years and improve Interest coverage, increasing continuously from 3.91 in
1983 to 6.17 in 1987 (Exhibit 1). The combined effect of both will enhanced Du
Pont Rating.
 Impact on Competitive Strategy: Earning per Share (EPS) and Return on Equity
(ROE) will be lower compared to 40% Debt to Capitalization. CAGR will be 6%
and 3% for EPS and ROE (Exhibit 2).
 Impact on Volatility: 25% Debt will reduce Du Pont liabilities to pay the debt and
interest. It will also reduce exposure to risk.
 Impact on Profit Sharing: The Du Pont had to issue equities to raise funds for the
capital financing. The equities will be increase from $398 million in 1983 to $1271

2
million in 1987. It will also increase in the number of shares in profit from 9.5
million to 25.2 million. (Exhibit 1)

2. 40% Debt-Capitalization Ratio

 Impact on Financial Flexibility & Competitive Strategy: 40% debt to capitalization


ratio will reduce the flexibility and protection from market conditions.
 Impact on Bond Rating Medians: Du Pont will able to achieve 40% debt to capital
in four years. The Interest coverage will increase to 3.95 till 1985 but reduce
thereafter (Exhibit 1). The combined effect of both will degrade Du Pont Rating
and widen the spread from AAA rating.
 Impact on Competitive Strategy: Earning per Share (EPS) and Return on Equity
(ROE) will be higher compared to 25% Debt to Capitalization. CAGR will be 10%
and 5% for EPS and ROE. (Exhibit 2)
 Impact on Volatility: 40% Debt will increase Du Pont liabilities to pay the debt and
interest. It will also increase exposure to risk.
 Impact on Profit Sharing: The Du Pont had to issue equities to raise funds for the
capital financing but lower compared to 25% debt to Capitalization. The equities
will be raised will be zero for the years 1983,1984 and 1985, and $704 million and
$816 million for the years 1986 and 1987 respectively. The number of shares in
profit will be only 13 million (Exhibit 1).

Recommendation
Du Pont should target 25% Debt capital structure for next five years. The 25%
synchronize with the company conservative policy and operation insulation from
market volatility. It will also reduce cost of borrowing due to AA credit rating. Though
profitability indicators will be lower compared to one’s in 40% debt ratio, exposure to
risk and volatility will reduce.

Action Plan
Du Pont finance its fund requirement at 12.3% (Exhibit 3) fixed interest rate and issue
equity at $47 per equity (Exhibit 1) in forward contract.

(Word Count: 1007)

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Exhibits:
Exhibit 1 Projected Financial Results Under Two Financial Policy Alternatives

1983 1984 1985 1986 1987

40% Debt Scenario

Debt/total capitalization (%) 36.0 37.1 39.7 40.0 40.0


Interest coverage 3.67 3.88 3.95 3.89 3.86
Earnings per share ($) 4.20 4.98 6.02 6.31 6.62
Dividends per share ($) 2.38 2.74 3.31 3.56 3.64
Return on total capital (%) 7.9 8.6 9.3 9.3 9.2
Return on equity (%) 9.0 10.1 11.5 11.5 11.4
New equity issues ($ millions) 0 0 0 704 816
Number of shares sold (millions) 0 0 0 11.7 13.0
Price of Share ($) 60.2 62.8
Average Price of Share ($) 61.5

25% Debt Scenario

Debt/total capitalization (%) 33.8 31.4 28.2 25.0 25.0


Interest coverage 3.91 4.60 5.57 6.23 6.17
Earnings per share ($) 4.13 4.77 5.41 5.46 5.60
Dividends per share ($) 2.29 2.49 2.71 2.72 2.72
Return on total capital (%) 7.9 8.6 9.3 9.3 9.2
Return on equity (%) 8.8 9.8 10.7 10.4 10.2
New equity issues ($ million) 398 686 1,306 1,783 1,271
Number of shares sold (millions) 9.5 14.3 28.8 36.2 25.2
Price of Share ($) 41.9 48.0 45.3 49.3 50.4
Average Price of Share ($) 47.0

Exhibit - 2 Projected Financial Results Under Two Financial Policy Alternatives

1983 1984 1985 1986 1987 CAGR

40% Debt Scenario

Earnings per share ($) 4.20 4.98 6.02 6.31 6.62 10%
Return on equity (%) 9.0 10.1 11.5 11.5 11.4 5%

25% Debt Scenario

Earnings per share ($) 4.13 4.77 5.41 5.46 5.60 6%


Return on equity (%) 8.8 9.8 10.7 10.4 10.2 3%

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Exhibit - 3 Interest rates in 1983

Description 1982 Source of Figure

Exhibit 1 E.I. Du Pont de Nemours Company (dollar


Interest expense 739
figures in millions, except per-share data)

Exhibit 2 Selected Funds Needs Data 1965-1982


Short Term Debt 319
(dollar figures in millions)

Exhibit 2 Selected Funds Needs Data 1965-1982


Long Term Debt 5,702
(dollar figures in millions)

Total Debt 6,021

Interest Rate 12.3%