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Du Pont Titanium Dioxide - Assumptions

1972
Size of Market
Cost of New Capacity/Ton
Pre-Tax Operating Expense/Ton
Market Share
Maintain
Growth
Average Selling Price/Ton
Maintain
Growth
Capacity
Maintain
Growth

1973
-

325
325

1974
-

1975
-

1976
-

1977
-

1978
-

1979
-

1980
-

1981
-

1982
-

1983
-

1984
-

1985
-

752
900
330

774
927
390

798
955
460

822
983
540

846
1013
580

872
1043
620

898
1075
660

925
1107
690

952
1140
710

981
1174
740

1010
1210
770

1041
1246
810

1072
1283
850

0.35
0.35

0.40
0.40

0.45
0.47

0.45
0.47

0.45
0.51

0.45
0.52

0.45
0.52

0.45
0.55

0.45
0.58

0.45
0.59

0.45
0.62

0.45
0.62

0.45
0.64

555
540

665
640

760
750

890
880

955
950

1015
1010

1070
1070

1120
1130

1170
1190

1210
1250

1270
1310

1320
1370

1370
1430

340
350

350
375

360
400

370
421

381
443

392
475

404
505

416
530

428
552

441
579

455
616

468
645

482
685

Du Pont Titanium Dioxide - Do Nothing


Do Nothing - Stay at Existing Capacity ( 325,000 tons ) and Allow Sales to Grow Until Full Capacity is Reached
1972
Unit Sales (1000 Tons)
Sales
Costs
Pre-tax Profits
Taxes
After-tax Profits
Plus Depreciation
Operating Cash Flow
Less Change in NWC
Less Change in FA
Plus Investment Tax Credit
Recovery
Net Working Capital
Plant & Equipment
Total Cash Flow

100000

1973

1974

1975

1976

1977

1978

1979

1980

1981

1982

1983

1984

1985

263
146076
86856
59220
28426
30794
0
30794
9215
0
0

310
205884
120744
85140
40867
44273
0
44273
11962
0
0

325
247000
149500
97500
46800
50700
0
50700
8223
0
0

325
289250
175500
113750
54600
59150
0
59150
8450
0
0

325
310375
188500
121875
58500
63375
0
63375
4225
0
0

325
329875
201500
128375
61620
66755
0
66755
3900
0
0

325
347750
214500
133250
63960
69290
0
69290
3575
0
0

325
364000
224250
139750
67080
72670
0
72670
3250
0
0

325
380250
230750
149500
71760
77740
0
77740
3250
0
0

325
393250
240500
152750
73320
79430
0
79430
2600
0
0

325
412750
250250
162500
78000
84500
0
84500
3900
0
0

325
429000
263250
165750
79560
86190
0
86190
3250
0
0

325
445250
276250
169000
81120
87880
0
87880
3250
0
0

82940

69050
0
153680

21579

32311

42477

50700

59150

62855

65715

69420

74490

76830

80600

Du Pont Titanium Dioxide - Maintain Strategy


Maintain Strategy
1972
Unit Sales (1000 Tons)
Sales
Costs
Pre-tax Profits
Taxes
After-tax Profits
Plus Depreciation
Operating Cash Flow
Less Change in NWC
Less Change in FA
Plus Investment Tax Credit
Recovery
Net Working Capital
Plant & Equipment
Total Cash Flow
Incremental Cash Flow

100000

1973
263
146076
86856
59220
28426
30794
0
30794
9215
13500
1350

9429
-12150

1974

1975

1976

310
359
205884 272916
120744 165186
85140 107730
40867 51710
44273 56020
0
0
44273 56020
11962 13406
9270
9550
927
955

370
329211
199746
129465
62143
67322
0
67322
11259
9830
983

23968
-8343

34018
-8459

47216
-3484

1977

1978

381
392
363569 398286
220806 243288
142763 154998
68526 74399
74237 80599
0
0
74237 80599
6871
6944
11143 11473
1114
1147

57336
-1814

63330
475

1979

1980

1981

1982

1983

1984

1985

404
416
432387 466200
266706 287213
165681 178988
79527 85914
86154 93074
0
0
86154 93074
6820
6763
12900 13284
1290
1328

428
501228
304164
197064
94591
102473
0
102473
7006
13680
1368

441
534155
326673
207482
99591
107890
0
107890
6585
15262
1526

455
577215
349965
227250
109080
118170
0
118170
8612
16940
1694

468
618354
379445
238910
114677
124233
0
124233
8228
16198
1620

482
660888
410040
250848
120407
130441
0
130441
8507
17962
1796

67724
2009

74355
4935

83156
8666

87569
10739

94312
13712

112178
170992
101427 388938
18487 235258

Du Pont Titanium Dioxide - Growth Strategy


Growth Strategy
1972
Unit Sales (1000 Tons)
Sales
Costs
Pre-tax Profits
Taxes
After-tax Profits
Plus Depreciation
Operating Cash Flow
Less Change in NWC
Less Change in FA
Plus Investment Tax Credit
Recovery
Net Working Capital
Plant & Equipment
Total Cash Flow
Incremental Cash Flow

100000

1973

1974

1975

1976

1977

1978

1979

1980

1981

1982

1983

1984

1985

263
142128
86856
55272
26531
28741
0
28741
8426
22500
2250

310
198144
120744
77400
37152
40248
0
40248
11203
23175
2318

375
281295
172528
108767
52208
56559
0
56559
16630
23875
2388

386
339979
208624
131356
63051
68305
0
68305
11737
20643
2064

431
409887
250247
159640
76627
83013
0
83013
13982
22286
2229

453
457974
281133
176842
84884
91958
0
91958
9617
33376
3338

467
499647
308194
191454
91898
99556
0
99556
8335
32250
3225

509
574888
351038
223850
107448
116402
0
116402
15048
27675
2768

552
657070
392034
265037
127218
137819
0
137819
16437
25080
2508

579
723488
428305
295183
141688
153495
0
153495
13283
31698
3170

626
820322
482174
338148
162311
175837
0
175837
19367
44770
4477

645
884225
522790
361435
173489
187946
0
187946
12781
36134
3613

686
981094
583168
397926
191005
206922
0
206922
19374
51320
5132

142645
59705

176219
394782
712361
558681

66
-21513

8187
-24124

18441
-24035

37989
-12711

48974
-10176

52302
-10553

62196
-3519

76446
7026

98811
24321

111683
34853

116177
35577

Du Pont Titanium Dioxide - Excess Capacity

Growth Strategy
Year Excess Capacity
1973 86.80 tons
1974 65.40 tons
1975 24.94 tons
1976 34.66 tons
1977 11.54 tons
1978 21.56 tons
1979 38.04 tons
1980 18.50 tons
1981 0.00 tons
1982 0.00 tons
1983 10.00 tons
1984 0.00 tons
1985 1.00 ton

Maintain Strategy
Year Excess Capacity
1973 76.80 tons
1974 40.40 tons
1975 1.00 ton
1976 0.00 tons
1977 0.00 tons
1978 0.00 tons
1979 0.00 tons
1980 0.00 tons
1981 0.00 tons
1982 0.00 tons
1983 0.00 tons
1984 0.00 tons
1985 0.00 tons

Du Pont Titanium Dioxide - Competitive Positions

Du Pont
Operating Profit Margin = 40%
Debt/Total Capital
= 9%

National Lead
Operating Profit Margin < 20%
Debt/Total Capital
= 35%

NPV Profiles
NPV Profiles for Growth, Maintain, and Difference Strategies

700000

600000

N e t P r e s e n t V a lu e s

500000

400000

Maintain
300000

Growth

200000

100000

0
0.00

0.05

0.10

0.15

-100000
Discount Rates

0.20

0.25

Du Pont Titanium Dioxide - Sensitivity Analysis


Variable (% of Projection)

NPV (10%) Maintain

NPV (10%)Growth

62,458

140,037

-616

10,217

-1

7,769

Market Share (87%)

-1,417

61,554

NWC Recovery (0%)

49,965

108,994

Plant Recovery (0%)

36,702

80,573

NWC & Plant (0%)

24,209

49,530

NWC & Plant (0%) and


Cost of Capital (150%, or 15%/10%)

5,540

5,686

Base Case (100%)


Costs (140%)
Sales Price (75% )

Antitrust Concerns?

Herfindahl-Hirshman Index (HHI)


The sum of the squared market shares of firms in the industry

Department of Justice (DOJ) 1984 merger guidelines


Range of HHI
Category
Less than 1,000
Low
1,000 to 1,800
Moderate
Greater than 1,800
High

Unfair Competition?

Challenge Change
NA
100
50

Du Ponts Strategy
Build Capacity to deter Competition
Price Titanium Dioxide to Capture the Market
Restrict Licenses of its Ilmenite Process

Bond and Stock Valuation


The market value of the firm is the present value of the cash flows
generated by the firms assets:

CFt
PV
t
t 0 (1 r )
N

The cash flows generated by the firms assets are divided among the
investors who pay for the assets. If these investors include only debt
and equity holders, the market value of the firm can be expressed as:
PVfirm = PVdebt+ PVStock

Bond (Debt) Valuation


The price of bonds in the market place is the present value
of the cash flows that bondholders have claim to:
N

CFd ,t

t 1

(1 rd ) t

PVd

These cash flows consist generally of two components,


interest and principal. They are generally divided as
follows:
N
I
P
PVd

t 1

(1 rd )

(1 rd ) N

That is, interest is paid every period, and the principal is


paid at maturity, when the bond comes due.

Bond Valuation (Continued)


Terms:
Coupon Payment: the interest paid annually, or semiannually (I).
Typically, these payments are fixed so that the interest paid each
year is the same.
Principal: the amount borrowed, and repaid at maturity (P).
Coupon Rate: the annual interest payment divided by the principle
(I/P)
Current Yield: the annual interest payment divided by the price
(I/PV)
Capital Gains Yield: the change in price (over one year) divided by
the price at the beginning of the year [(PV1-PV0)/ PV0]
Yield to Maturity: the return investors expect if they buy the bond
and hold it until it matures. If the market is in equilibrium, the yield
to maturity is also the return investors require given the bonds risk
(rd).

Bond Valuation (Continued)


Numerical Example: Suppose a bond with 10 years to maturity has a
coupon rate of 10%, a principal amount of $1,000, and a yield-to-maturity
of 10%. Assuming interest is paid annually and the bond is in equilibrium,
What is the price of the bond?
100
1,000

?
t
10
t

1
(
1
.
10
)
(
1
.
10
)
What is its current yield?
10

PVd

Current Yield = I/PV =

What is its expected capital gains yield?


Capital Gains Yield = [(PV 1-PV0)/ PV0] =

Bond Valuation (Continued)


Suppose now that everything else remains constant, but the yield to
maturity is 12%. What are the price, the current yield, and the
expected capital gains yield?
100
1,000

?
t
10
t 1 (1.12)
(1.12)
10

PVd

Current Yield = I/PV =

Capital Gains Yield = [(PV1-PV0)/ PV0] =

What would cause the yield to maturity to be 12% instead of 10%?

Bond Valuation (Continued)


The yield to maturity, the return investors expect, is linked to the return
investors require, rd.
The required return, rd , is a function of
The real rate of return - the return investors require for deferring consumption
(that is, the time value of money)
The expected rate of inflation - the compensation investors require to guard
against losses in their purchasing power.
The risk premium - the compensation investors require to accept the
possibility that their return will be lower than what they were promised.

If rd is 12%, not 10%, one or more of the three components of the


required rate of return must be higher in the second instance than in the
first.
Why is yield to maturity linked to rd?

Bond Valuation (Continued)


Suppose the expected rate of return does not equal the required rate of
return. If the bond above should be priced at $887 because the
required rate of return is 12%, but it is priced at $1,000 to give an
expected return of 10%, investors are not being compensated for the
risk that they bear.
The NPV from buying the bond will be negative (887-1,000), so new
investors will not buy.
The NPV from selling the bond will be positive (1,000-887), so existing
investors will want to sell.
The combination of new investors not buying and existing investors
wanting to sell will cause the price of the bond to fall.
How far? Why?

Bond Valuation (Continued)


Risk Return Relationship
20.00%

18.00%

16.00%

14.00%

Return

12.00%

10.00%

8.00%

6.00%

4.00%

2.00%

0.00%
0.0

0.2

0.4

0.6

0.8

1.0

Risk

1.2

1.4

1.6

1.8

2.0

Bond Valuation (Continued)


Sensitivity of Bond Prices to Changing Interest Rates

Price of Bond Relative to $100 Beginning Point

300.00

250.00

200.00

150.00

100.00

50.00

0.00
4.00%

6.00%

8.00%

10.00%
Yield to Maturity

12.00%

14.00%

16.00%

Bond Valuation (Continued)


Spreads Betw een Corporate and Government Bonds

1200

Basis Point Spreads

1000
800
600
400

S7

200

S4
S1

0
Aa2/AA

A2/A

Baa2/BBB
Ratings

Ba2/BB

B2/B

Years to
Maturity

Stock Valuation
The price of stocks in the market place is the present value
of the cash flows that stockholders have claim to:
N

CFs ,t

t 1

(1 rs ) t

PVs

These cash flows consist generally of two components,


dividends and capital gains. They are generally divided as
N
PVs , N
Divt
follows:
PVs , 0

t 1

(1 rs )

(1 rs ) N

Stock Valuation (Continued)


What are the differences between bond and stock cash flows?
Interest vs Dividends
Interest is paid before dividends.
Interest is generally fixed ; dividends are variable.
Interest is a contractual obligation; dividends are discretionary.

Principal vs. Future Stock Prices


Principal is contractually binding to the firm; future stock prices are not.
In liquidation, claims to both principle and interest must be satisfied before
payments can be made to stockholders

What do these differences imply about potential differences between r s


and rd?

Stock Valuation (Continued)


Risk Return Relationship
20.00%

18.00%

16.00%

14.00%

Re tu rn

12.00%

10.00%

8.00%

6.00%

4.00%

2.00%

0.00%
0.0

0.2

0.4

0.6

0.8

1.0

Risk

1.2

1.4

1.6

1.8

2.0

Stock Valuation (Continued)


If, for simplicity, we assume that dividends grow forever at a constant
rate, g, and that that rate is lower than the required rate of return on
the stock, rs, then the present value of the dividends and future stock
price can be expressed as
Div1
PVs , 0
rs g
This says that the price of the stock today equals the expected dividend
one year from today (Div1) divided by the difference between the
required rate of return and the constant growth rate (r s-g)
Under these same assumptions, the required return on the stock could
Div1
be estimated as
rs
g
PVs , 0

Stock Valuation (Continued)

Suppose the expected dividend next period (D1) is $1.50, the expected
constant growth rate (g) is 8%, and the required return (r s)on the stock is 15%.
What is the price of the stock today

P0 = D1/(rs-g) = $1.50/(.15-.08) = $21.43

What are the expected current (or dividend) yield and capital gains yield?

Current Yield = D1/P0 = $1.50/$21.43 = .07 or 7%


Capital Gains Yield = ?

How does the stock price relate to the NPV of projects undertaken by the
firm?

Stock Valuation (Continued)


How does the stock price relate to capital budgeting decisions of the
firm? The NPV of projects undertaken by firms is reflected in stock
prices as follows

PVs , 0

EPS1
NPVGO
rs

The first component, EPS1/rs, is the price of the stock if equity cash
flows (or earnings) remain constant forever. The second component
is the expected NPV from future growth opportunities.
What determines whether NPVGO is positive or negative?

Stock Valuation (Continued)


By setting the two stock pricing relationships equal to each other and
recognizing that (Div1/EPS1) equals 1-b, where b is the firms retention
ratio, and g is the ROE*b, we can express NPVGO as
NPVGO EPS1

b * ( ROE rs )
rs * ( rs g )

The above relationship tells us that NPVGO will be positive so long as


the ROE on the investment exceeds the required rate of return,r s

Stock Valuation (Continued)


Assumptions
ROE
Retention Ratio
Payout Ratio
Required Return
Growth
Expected Earnings without Investment
Time
Earnings with No New Investment
Present Value of Earnings
Amount Retained
Additional Earnings from Investment
PV of Additional Earnings
NPV of Additional Earnings
Total Earnings
Amount Retained
Additional Earnings from Investment
PV of Additional Earnings
NPV of Additional Earnings
Total Earnings
Amount Retained
Additional Earnings from Investment
PV of Additional Earnings
NPV of Additional Earnings

20.00%
40.00%
60.00%
15.00%
8.00%
2.50
0
$
$

1
2.50 $

(1.00)

1.33

4
2.50 $

5
2.50 $

6 .
2.50 $

2.50

.
$

2.50

0.20

0.20

0.20

0.20

0.20

0.20

0.20

2.50

2.70 $
(1.08)
$
1.44

2.70

2.70

2.70

2.70

2.70

2.70

0.22

0.22

0.22

0.22

0.22

0.22

2.92 $
(1.17)
$
1.56

2.92

2.92

2.92

2.92

2.92

0.23

0.23

0.23

0.23

0.23

0.29
$
$
$

3
2.50 $

16.67

$
$

2
2.50 $

0.27
$

2.50

2.70

$
$
$

0.26

Stock Valuation (Continued)


What would happen if the firm could make these investments
indefinitely by retaining 40% of its earnings and producing ROEs of
20%?
NPVGO EPS1

b * ( ROE rs )
rs * ( rs g )

.4 * (.20 .15)
$4.76
.15 * (.15 .08)

$2.50 *

What would the price of the stock be?


EPS1/rs + NPVGO = $2.5/.15 + $4.76 = $21.43

Stock Valuation (Continued)


How does that coincide with the earlier model

PVs ,0

Div1
$1.50

$21.43
rs g (.15 .4 * .20)

How does the model we have just discussed relate to EVA, if it does?

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