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Du Pont De Nemours and Company Case Analysis

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Du Pont de Nemours and Company Case Analysis

In assessing Du Pont’s capital structure after the Conoco merger that significantly increased the company’s debt to equity ratio, an analyst must look at all benefits and drawbacks of a high debt ratio. The main reason why Du Pont ended up with a high debt to equity ratio after acquiring Conoco was due to the timing and price at which they bought Conoco. Du Pont ended up buying the firm at its peak, just before coal and oil prices started to fall and at a time when economic recession hurt the chemical industry of Du Pont. The additional response from analysts and Du Pont stockholders also forced Du Pont to think twice about their new expansion. The thought of bringing the debt ratio back to 25% was brought on by the fact that the company saw that high levels of capital spending were vital to the success of the firm and that high debt levels may put them at higher risk for defaulting.

The consistent high spending of capital equipment is the first reason why one would recommend reducing the debt to equity ratio. A company with higher levels of debt is less flexible in being able to adjust to new market demands and conditions that require the company to make new products or respond to competition. Looking at the pecking order of financing, issuing new shares to fund capital investing is the last resort and a company that has high levels of debt, must move to the equity side to avoid the risk of bankruptcy. Defaulting on loans occur when increased costs or bad economic conditions lead the firm to have lower net income than the payments on loans. The risk of defaulting on loans and the direct and indirect cost related to defaulting lead firms to prefer lower levels of debt. The financial distress caused by additional leverage can lead to lower cash flows available to all investors, lower than if the firm was financed by equity only. Additionally, the high debt ratio that Du Pont incurred also led to them dropping from a AAA bond rating to a AA bond Rating. Although the likelihood of not being able to acquire loans would be minimal, there are increased interest costs with having a lower bond rating. The lower bond rating signals to investors that the firm is more likely to default than if it had a higher (AAA) bond rating. This could impact cause suppliers and investors to be less interested in the company.

There are many benefits to the company deciding to maintain its current 36% debt ratio and why it may be beneficial. The most viable reason to keep the current debt ratio is due to the tax shield benefits that the debt provides. The current tax shield is shows that Du Pont has higher EPS, dividends per share, and return on equity with the higher level of debt. This alone is one reason that would please current stockholders. If the firm was to try to decrease the debt ratio it would have to finance future debt with issuance of stock. The issuance of stock signals to the public that the firm is under financial distress and is not confident in its new projects to cover the cost of capital. This alone makes the value of the firm decrease immediately. The only time one should issue share is if the firm is overvalued. Additionally, the firm continuing to issue debt to finance capital investments is viewed as a positive, as investors see that the firm as being liquid and can cover its cost through sales of assets if needed. As long as the Asset value exceeds the debt, value the firm shows that it is liquid. Although reducing the debt level is beneficial, the firm had already established a presence as a company that was comfortable with financing with debt. It looks bad for a company to switch its capital spending from debt to equity financing as it shows that it shows signs of financial distress.

Secondly, looking at the firms that are in the same industry, the majority of the firms also have high debt ratios and this indicates that they would be just as inflexible as Du Pont in responding to market conditions. Looking at Monsanto’s debt ratio in 1982, they

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