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Case Questions for Du Pont – Fall 2020 1. In generally, how should a firm determine its appropriate capital structure? 1) What impact does leverage have on the prospects and performance of a company? 2) What problems arise from employing too much debt? too little debt? 3) What indications does a firm have that its leverage is too high? too low? 4) What issues relating to competitive strategy arise in the determination of capital structure policy? 5) What factors are responsible for differences in debt ratios for firms in different industries? for firms in the same industry? Analyze Du Pont’s financing policy: 2. How will Du Pont's CFO be spending his or her time over the next several years? 3. How much external funds will Du Pont have to raise in the near future? 4. What is driving this need for external financing? 5. Why is a financing policy important to Du Pont? 6. Why should a firm have a capital structure policy, i.e., a target debt ratio? Analyze Du Pont’s bond rating: 7. Why is a AAA rating important to Du Pont? How and why did Du Pont keep its AAA rating in 1975? 8. Why did Du Pont abandon its AAA debt-rating policy? What were the consequences? What is the role of bond ratings? 9. Compare and contrast the two debt policy alternatives outlined in case Exhibit 8 for 1987. What bond rating would Du Pont receive under each alternative using the data in Exhibit 8 and Exhibit 4? How would its financial performance, financing needs, access to capital, and financial risk differ under the two alternative debt policies? 10. How are the issues of bond rating and target debt ratio related in the case of Du Pont? Du Pont’s capital structure policy: 11. What capital structure policy should the company adopt now? What issues should it consider? E.I. Du Pont de Nemours and Company—1983 Harvard Business School 9-284-062 Rev. November 15, 1993 This case was prepared as the basis for class discussion rather than to illustrate either effective or ineffective handling of an administrative situation. Copyright © 1984 by the President and Fellows of Harvard College. To order copies or request permission to reproduce materials, call 1-800-545-7685, write Harvard Business School Publishing, Boston, MA 02163, or go to http://www.hbsp.harvard.edu. No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means—electronic, mechanical, photocopying, recording, or otherwise—without the permission of Harvard Business School. 1 E.I. Du Pont de Nemours and Company—1983 In early 1983, the management of E.I. Du Pont de Nemours and Company looked back on two decades of turbulence in the firm’s operations. Difficulties in the 1970s and the “mega-merger” with Conoco, Inc. had led the company to abandon its long-held policy of an all equity capital structure. Following the Conoco acquisition in 1981, Du Pont’s ratio of debt to total capital had peaked at 42%—the highest in the firm’s history. The rapid escalation in financial leverage had cost Du Pont its cherished AAA bond rating. Du Pont had not regained the top rating despite a reduction in debt to 36% of capital by the end of 1982. The operations of Du Pont had changed dramatically in the past twenty years. With the task of digesting Conoco underway, management faced an important financial policy decision— determining a capital structure policy appropriate for Du Pont in the 1980s. This decision would have implications for Du Pont’s financial performance and possibly for its competitive position as well. The Company E.I. Du Pont de Nemours and Company was founded in 1802 to manufacture gunpowder. By 1900, Du Pont had begun to expand rapidly through research and acquisition. A technological leader in chemicals and fibers, the firm grew to be the largest U.S. chemical manufacturer. At the end of 1980 the firm ranked fifteenth on the Fortune 500 list of U.S. industrials. The 1981 merger with Conoco, Inc., a major oil company, elevated Du Pont to seventh place on the list of U.S. industrials. Capital Structure Policy, 1965-1982 Historically Du Pont had been well known for its policy of extreme financial conservatism. The company’s low debt ratio was feasible due in part to its success in its product markets. Du Pont’s high level of profitability allowed it to finance its needs through internally generated funds (see Exhibits 1 and 2 for selected financial data). In fact, financial leverage was actually negative between 1965 and 1970 since Du Pont’s cash balance exceeded its total debt. Du Pont’s conservative use of debt combined with its profitability and technological leadership in the chemical industry had made the company one of the few AAA rated manufacturers. Du Pont’s low debt policy maximized its financial flexibility and insulated its operations from financing constraints. For the exclusive use of R. Apinageri, 2020. This document is authorized for use only by Rachael Apinageri in FINC6602_Fall_2020-1 taught by FANG CHEN, University of New Haven from Sep 2020 to Dec 2020. 284-062 E.I. Du Pont de Nemours and Company--1983 2 In the late 1960s competitive conditions in Du Pont’s fibers and plastics businesses began to exert pressure on the firm’s financial policy. Between 1965 and 1970, increases in industry capacity outstripped demand growth resulting in substantial price declines. As a result, Du Pont experienced decreases in gross margins and return on capital. Despite continued sales growth, net income fell by 19% between 1965 and 1970. Three factors combined to intensify the pressure on Du Pont’s financing policy in the mid 1970s. 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. Secondly, the rapid increase in oil prices in 1973 pushed up Du Pont’s feedstock costs and increased required inventory investment while oil shortages disrupted production. Du Pont experienced the full impact of the oil shock in 1974; its revenues rose by 16%, costs jumped by 30%, causing net income to fall by 31%. Finally, the recession in 1975 had a dramatic impact on Du Pont’s fiber business. Between the second quarter of 1974 and the second quarter of 1975, Du Pont’s fiber shipments dropped by 50% on a volume basis. Net income fell by 33% in 1975. Over the period 1973-1975 Du Pont’s net income return on total capital and earnings per share all fell by more than 50%. Severe financing pressures resulted from the combination of inflation’s impact on needed capital expenditures, cost increases driven by the escalation in oil prices, and recessionary conditions in the fibers business. The required investment in working capital and capital expenditures increased dramatically at a time when internally generated funds were shrinking. Du Pont responded to the financing shortfall by cutting its dividend in 1974 and 1975 and slashing working capital investment. Since these measures were insufficient to meet the entire financing requirement, Du Pont turned to debt financing. With no short-term debt outstanding in 1972, the firm’s short-term debt rose to $540 million by the end of 1975. In addition, in 1974 Du Pont floated a $350 million 30 year bond issue and a $150 million issue of 7 year notes. The former was Du Pont’s first public long-term debt issue in the U.S. since the 1920s. As a result, Du Pont’s debt ratio rose from 7% in 1972 to 27% in 1975 while interest coverage collapsed from 38 to 4.6 over the same period. Despite concern that the rapid run up in the company’s debt ratio might result in a downgrading, Du Pont retained its AAA bond rating during this period. Had Du Pont abandoned its policy of financial conservatism or was this a temporary departure from that policy forced by extraordinary financing pressures? In December 1974 Du Pont CEO Irving Shapiro stated: “We expect to use prudent debt financing over the long term.” Nonetheless, Du Pont moved quickly to reduce its debt ratio. Between 1976 and 1979 financing pressures eased. Capital expenditures declined from their 1975 peak as the spending program initiated in the early 1970s neared completion. Net income more than tripled during the period 1975-1979 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 Pont’s debt had been pared to about 20% of total capital and interest coverage had rebounded to 11.5 from 4.6 in 1975. Once again the firm was well within the AAA rated range. However, it was not apparent that the firm would return to the zero debt policy of the past. In 1978 Richard Heckert, a Du Pont senior vice president, noted: “While we presently anticipate some further reduction in borrowings, we have considerable borrowing capacity and hence considerable flexibility.” An abrupt departure from maximum financial flexibility occurred in the summer of 1981. In July, Du Pont entered a bidding contest for Conoco, Inc., a major oil company and the fourteenth largest U.S. industrial. After a brief but frenetic battle, Du Pont succeeded in buying Conoco in August 1981. The price of almost $8 billion made the merger the largest in U.S. history and For the exclusive use of R. Apinageri, 2020. This document is authorized for use only by Rachael Apinageri in FINC6602_Fall_2020-1 taught by FANG CHEN, University of New Haven from Sep 2020 to Dec 2020. E.I. Du Pont de Nemours and Company--1983 284-062 3 represented a premium of 77% above Conoco’s pre-acquisition market value. With the acquisition, Du