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Dupont Case

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Du Pont Capital Structure Decision
RESULT

THEORY

Explain

MM - 0 taxes

No transaction costs; no restrictions or costs to short sales; and individuals capital structure is can borrow at the same rate as corporations. irrelevant No preference for low debt versus high debt; unrealistic assumptions.

Allows interest to be deducted, reduces taxes paid by levered firms; debt
"shields" some of the firm's cash flow from taxes.

The firm's value increases continuously as more and more debt is used.
The cost and availability of debt might affect its ability to pursue capital spending programs

MM - Corporate
Taxes

MM - Corporate
Taxes & Personal
Taxes

Tradeoff

The Pecking Order

Free Cash
Flow/Managerial
Constraint

40 % Debt Scenario

Personal taxes lessen the advantage of corporate debt: corporate taxes favor debt financing since corporations can deduct interest expenses.
Personal taxes favor equity financing, since no gain is reported until stock is sold, and long-term gains are taxed at a lower rate. The use of debt
40 % Debt Scenario financing remains advantageous, but benefits are less than under only corporate taxes. Firms should still use 100% debt.
Ignores bankruptcy (financial distress) costs, which increase as more leverage is used. At low leverage levels, tax benefits outweigh bankruptcy costs. At high levels, bankruptcy costs outweigh tax benefits. An optimal capital structure exists that balances these costs and benefits.

According to Exhibit 6, DuPont will be able to fund about 78% of its 19831987 needs internally from operational cash flows, asset sales, etc. But a significant - and growing - amount will need to be financed separately to fund capital expenditures and NOWC increases viewed as nondiscretionary. The Pecking Order Hypothesis indicates that as much as possible of this financing

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