B.A. 142 CASE 2
EXECUTIVE SUMMARY
E. I. du Pont de Nemours is an American chemical company that has recently acquired the major oil company of Conoco Inc. and is becoming one of the largest chemical manufacturers in the United States. Its financial conservatism has pushed Du Pont to the forefront of the industry as its profitability soared, providing it with the liquidity to readily finance its cash needs. But several competitive conditions posed a challenge to its risk averse financial policy as the 1970's was characteristic of a declining level of industry demand and price, along with rising fuel prices and an economic recession. These pressures now force Du Pont to source its financing through debt, foregoing its risk averse capital structure policy in the past. It now aims to determine the most feasible capital structure that will enable it to finance capital expenditures vital to its competitive advantage while maintaing its financial flexibility.
Du Pont now faces two alternatives: 1) Reduce the debt/total capitalization ratio from 36% to 25% by issuing large equity instruments in the next 5 years, or 2) Maintain a 40% debt ratio, allowing it to provide higher EPS, dividends/share and return on equity.
Firstly, we calculate the cost of capital in order to determine the capital structure that maximizes the value of the firm. We then incorporate other qualitative considerations including financial flexibility, risk and consistency with DuPont's goals. Lastly, we compare each alternative's effect on EPS, its changes in company ratings and the deviations from industry standards.
The weighted average cost of capi ...