E.I. Du Pont (1983) Case
E.I. Du Pont (1983) Case
1. Reasons why the firms use capital structure policy; target debt ratio
A capital structure policy is essential for firm due to the management and sourcing of capital to achieve corporate strategy. It determines where the funds will come from both internally and externally. (Biais, 2002). There are various forms of capital strategy, which include a target debt ratio. In this policy, the ratio of debt is the tool that is used to manage the capital structure in a company.
The capital structure policy also enables the company to know which form of financing is cheaper. The companies, which use the target debt ratio such as Du Point, select low debt ratio of about 25%. This enables the company to remain relevant, and they do not incur high costs of debts during their operations (Bragg, 2007).
Maintaining high debt ratio gives a company a comparative advantage because the EPS rises. The Capital structure policy is thus vital for improving the EPS in the Company (Biais, 2002). The Shareholders benefit most when policy is implemented properly.
Another importance of capital structure system, the target debt ratio is to reduce the tax liability through debt (James, 2009). The financing of the company through debt is exempted from taxation (Biais, 2002). This reduces the financial distress in a company. A company that uses more debt than capital benefit from high debt ratio to equity.
2. Debt financing of two policies with different percentages
In the debt ratio of 40%, the projected rating is AAA/AAA while the debt ratio of 40% is A/BBB. The AAA rating is usually maintained at 17% debt ratio; however, the Du Point has continually applied it even at higher percentages. The rating at 25% drops to AA while t 40% it drops even more to BBB.
The EPS in the debt policy that has higher debt policy of 60% is higher than the policy that has 25%. When the debt ratio is high, the earnings per share are also high. This is because when the debt ratio is high, the company enjoys the benefit of paying less tax (James, 2009). Debt financing is not taxable. This makes the profits that the shareholders accrue increase hence higher EPS.
The price stock for the 25% debt ratio is $56, which is lower than $ 66.20 for 40% debt ratio. This is because of the direct relationship between cost of debt and cost of equity.
The debt policy of 25% earns the company lower return on equity (ROE) as compared to the 40% debt ratio. When the debt ratio is high, the risk level is also high. High debt ratios have high risks and high returns on the assets.
The Divided per share is lower to the debt ratio that has 40% debt ratio. This is because the returns of a policy that has a high percentage are more. The shareholder thus benefit from this policy.
3. Firm’s determination of Capital Structure
The firm should consider the debt ratio that it will use as a form of capital structure policy. It should consider its objectivity, risk and the level of returns.
(a). leverage on the performance of the company.
The leverage makes the company reduce cost due to the nature of debt financing not being taxable. This makes the firm to benefit from taxation that would have added to the cost of the business (Biais, 2002). The company will use the proceedings that would have gone to taxation to improve itself through expansion or services that they offer. The performance of the company will also be enhanced.
(b). Disadvantages of high debt financing
Employing too much debt in the capital structure of the company is not always beneficial to the company. It shows that the company cannot cater for its short term and long-term obligations (Biais, 2002). This makes a company to be lowly rated.
In the event that a company wants to source funds externally, the debt ratio is a factor that financial institutions or creditors consider most. It shows the capability of the company to settle debts. No institution would lend a company that has heavy debt (Bragg, 2007). This makes it hard for the company to access finances externally.
The high debt ratio also shows inefficiency of the management in a company (Bragg, 2007). This is one way to show the inefficiency of the management of the company. High debts show that the company is operating at a point when there are no enough returns from the business that is being operated (Bragg, 2007).
The high debt ratios also show that in the event of liquidation, the company cannot be able to carter for the liabilities that it may be having. A company that has high debt ratio is a risky company.
(c). Indicators of high or low debt ratio in a company
There are various indications that can be used to show that the firm has high debt or firm has low debt ratio. They include the inability of the firm to access external financing due to existing debts (James, 2009). Financial institutions consider it risky to enter into a contract with a company that has too much debt.
The time that the company uses to settle debts is also crucial in the determination whether it has high or low debt ratio. If the time is short, then the debt ratio is good. If it is long, it implies that the debt ratio is high (Bragg, 2007).
References
Biais, B., & P. M. (2002). New research in corporate finance and banking. Oxford: Oxford University Press.
Bragg, S. (2007). Business ratios and formulas: A comprehensive guide. Hoboken: Wiley.
James, W. G., & Simons, M. (2009). & University of Cape Town. (2009). Class, caste and color: A social and economic history of the South African Western Cape. New Brunswick: Transaction Publishers.
