Du Pont Capital Structure 1983

Prof. Jayanth R. Varma

Indian Institute of Management, Ahmedabad

©Prof. Jayanth R. Varma Indian Institute of Management, Ahmedabad 1/10

Du Pont & Pecking Order Theory

Pecking order theories would predict that low debt of the 1960s was
due to its high profitability
• No need for external capital
But situation has changed dramatically:
• Projections in Exhibit 6 show large capex needs that require external
financing year after year.
Pecking Order Theory would predict more reliance on debt now
• But Du Pont wants to reduce debt and increase equity

©Prof. Jayanth R. Varma Indian Institute of Management, Ahmedabad 2/10

Tradeoff Theory: Bankruptcy costs

Is Du Pont at any serious risk of bankruptcy?

Why does it want to be very low debt?
Is Du Pont’s business risk increasing?
• More volatile commodity prices, greater competition, lack of product
differentiation and the Conoco acquisition.
• Are these risks mitigated by technological leadership and plans to
achieve cost leadership (p 3-4)?

©Prof. Jayanth R. Varma Indian Institute of Management, Ahmedabad 3/10

Financial Flexibility

Du Pont’s financing policy sought to maximize financial flexibility.

• This insured that financing constraints did not interfere with the firm’s
competitive strategy. (p3)
Du Pont’s corporate strategy:
• “Capital spending was viewed as critical to Du Pont’s future success
because it was the key to minimizing the firm’s cost position in existing
products and launching new products swiftly and efficiently. In view of
its importance, capital spending was essentially non-deferrable and
often had to be increased rather than cut in bad times in order to
redress the causes of poor performance.” (p4)
• “In response to competitive pressures Du Pont in the early 1970s
embarked on a major capital spending program designed to restore its
cost position. The escalation of inflation ballooned the cost of the
program to more than 50% over budget by 1974. Since capital
spending was critical to maintaining and improving its competitive
position, Du Pont was reluctant to reduce or postpone these
expenditures.”

©Prof. Jayanth R. Varma Indian Institute of Management, Ahmedabad 4/10

Debt Market Imperfection

Do BBB rated firms lack market access in stressed market conditions

like 1979 and 1981 (Exhibit 7)?
Is an A rating sufficient to ensure market access?
Is an A rating at risk of downgrade to BBB under adverse conditions?
• For example, Celanese downgraded from A to BBB between 1980 and
1982 due to losses (Exhibit 6).

©Prof. Jayanth R. Varma Indian Institute of Management, Ahmedabad 5/10

Rating considerations

Credit rating is based on both quantitative ratios and qualitative

considerations
• Impute rating from key financial ratios
• Consider rating uplift based on Du Pont’s size and market leadership
What was the imputed rating in 1975?
Is it easier to retain rating than to regain it?
• In 1975, commitment to AAA rating was sufficient to retain the rating?
Can AAA rating be regained before actual fall in leverage and
improvement in coverage ratios?

©Prof. Jayanth R. Varma Indian Institute of Management, Ahmedabad 6/10

Imputed Ratings in 1983

Would 25% debt give Du Pont a AAA rating?

• It would only achieve an A/AA rating that might be upgraded to AA
because of qualitative considerations, but AAA looks elusive.
Would 40% debt give Du Pont an A rating required for unimpeded
debt market access?
• Rating imputed from ratios might be only BBB. This might be
upgraded to A based on qualitative considerations.
• Stressed scenario (1987) even BBB might be lost.

©Prof. Jayanth R. Varma Indian Institute of Management, Ahmedabad 7/10

Equity Market Imperfections

Large capital expenditure needs ⇒ substantial immediate new equity

raising under the 25% leverage ratio.
• The 40% leverage ratio implies no equity raising in the next three years.
Information asymmetry. Market disagrees with management on
Conoco merger:
• “As of the end of 1982, Du Pont’s stock price had yet to recover from
the market’s negative reaction to the Conoco merger reinforced by the
continuing recession.” (p 4)
Is access to equity market assured?
• “This raised questions concerning the terms and availability of the
substantial new equity financing required to achieve a 25% debt ratio”
(p 4)

©Prof. Jayanth R. Varma Indian Institute of Management, Ahmedabad 8/10

What did Du Pont do?

Du Pont chose to attempt to reestablish its AAA rating and reduced

its debt ratio to 20% by 1984.
• Asset sales
• Reductions in capital expenditures and working capital
• Equity issues
Du Pont was rated a strong AA in 1984 (S&P AA+, Moody’s Aal)
• AAA rating eluded them.
By 1990 energy accounted for 44% of sales and 46% of profits.

©Prof. Jayanth R. Varma Indian Institute of Management, Ahmedabad 9/10

Rating driven capital structure

Many companies (but not all) decide their capital structure based on
a target rating instead of a target leverage ratio.
Target rating depends on business strategy
• Other companies in chemical industry run with much higher debt than
Du Pont.
The target rating also depends on the extent of market imperfections:
• Today, in the US market, a BBB (and perhaps even lower) rating might
be enough to guarantee bond market access even in stressed conditions.
• In Indian bond market, a AA rating might be necessary.

©Prof. Jayanth R. Varma Indian Institute of Management, Ahmedabad 10/10