Case 35 deluxe corporation solution

Theme: Capital Structure and leverage

Assignment Case 3

Deluxe Corporation

Case 35 page 479

GUIDANCE SHEET

Synopsis

In July 2002, an investment banker advising Deluxe Corporation must prepare recommendations for the company’s board of directors regarding the firm’s financial policy. Some special considerations are the mix of debt and equity, maintenance of financial flexibility, and the preservation of an investment-grade bond rating. Complicating the assessment are low growth and technological obsolescence in the firm’s core business.

The objective is to recommend an appropriate financial policy for Deluxe Corporation and, in support of that recommendation, it is recommended to show the impact on the cost of capital, financial flexibility (i.e., unused debt capacity), bond rating, and other considerations.

Objectives

The following are the analytical objectives of this case study:

· Survey the determinants of corporate bond ratings. The case highlights the important influence of the rating agencies on the costs of debt and the access to capital markets. The case data afford students the opportunity to explore profitability, coverage ratios, and capitalization ratios as measures of credit quality.

· Explore the practical challenges involved in determining the optimal mix of debt and equity, in particular assessing the tradeoff between the benefits of debt tax shields and the costs of financial distress. The case affords the opportunity to highlight methodological problems in estimating the optimal mix.

· Consider the concepts of debt capacity and financial flexibility. The notion advanced in this case is that flexibility is the ability to access capital without falling short of the firm’s minimum target credit rating.

Introduction

In the check printing industry Deluxe has been one of the most dominant companies. The company occupies 49% of the market share and its compound annual was growing at the rate of 12%. The new forms of payments have really encroached on the demand of check printing industry. The demand greatly went down annually. There is a big challenge that is faced by the core business of Deluxe. The company opted to retain Singh was retained by the board of directors and asked him to come up with a plan for the new round of debt issuing. A clear indication is that at some point in the future the company will really struggle. In order to deal with the bad situation in the future, Deluxe must maintain the flexibility of its finances and ensure that it sets its cost of capital as low as possible through adopting the appropriate capital structure. This paper will be trying to find out the recommendations that can help Dluxe company to get back on truck with running its business.

Questions

1. What are the risks associated with Deluxe’s business and strategy? What financing requirements do you foresee for the firm in the coming years? ( HERE YOU ARE SUPPOSE TO ADD NUMBERS CHECK THE SAMPLE AGAIN PLEASE)

The nature of the Deluxe Corporation’s business is paper check printing.

In the late 1990’s, the firm’s strategy was to reduce expenses. They did this by divesting 20 non-core businesses, closing 49 plants, reducing its labor force by 8,000 employees, outsource IT and focus on improving manufacturing efficiencies.

Currently (2000’s), the Deluxe Corporation (DC) strategy has been to spin-off technology related subsidiaries. They spun-off eFunds and iDLX Technology Partners thru an initial public offering (IPO). Management believe there was more value in these companies are separate entities, and that these companies did not have valuable synergies.

The current strategy is very risky. iDLX Technology Partners offered technology related consulting services to financial service companies while eFunds offered electronic payment products and services. The CEO admits that the paper check business is dying, but spun-off a company that seems to be replacing it in eFunds. People were shifting from writing checks to using credit cards, debit cards and using electronic payment services over the internet, so a major risk that just occurred is DC just lost a huge growth company, and that company they just spun-off can come back and take market share from the paper check industry in the form of electronic payments. If the CEO is correct in predicting the demise of the paper check business, then it is likely that electronic payments would be the business the kill the paper check industry. Another risk is they lost diversification by spinning-off these two companies, especially losing the consulting service company; iDLX. The consulting service company could have provided a very different business than the payment business they were in.

Short term financing needs

Working capital, capital asset purchases, possible acquisitions, repayment of outstanding debts, dividend payments and repurchasing the firm’s securities.

In February 2001, Deluxe paid off $100 million of its 8.55% long-term unsecured and unsubordinated notes, which is had issued in 1991.

Repurchase program:

As shown as below, in the end of 2001, the company repurchase 11.3 million shares. Singhalso believe that the board would continue to pursue an aggressive program of share repurchase.

Other demands on the firms resources:

Cash dividends would be held constant for the foreseeable future. Capital expenditures would be about equal to depreciation for the next few years.

Considerations in assessing financial policy

In addition to assessing Deluxe’s internal financing requirements, singh recognized that his policy recommendations would play an important role in shaping the perceptions of the firm by bond-rating agencies and investors.

2. What are the main objectives of the financial policy that Rajat Singh must recommend to Deluxe Corporation’s board of directors?

Sihgh believed that it was essential that the company’s financial policies afford it the necessary funding and flexibility to steer a path to survivability. So, Rajat Singh recommended new debt program and stock-repurchase to the board of director. The main objective is to fend off the eventual disintegration of its core business.

Management’s key objective is to focus on its core business. By spinning-off eFunds and iDLX, DC can concentrate on its core business - which the CEO strongly feels still has growth opportunities. The core business is very profitable, and he states that can generate good revenue and profits from it over the next five years, and does not want to abandon a good business too early. After the spin-off, the company is repositioned as a pure-play check printing company. Since this is what their investors wanted, after the news of the spin-off, the stock rose. DC then used cash for company share buybacks. The share repurchase plan authorizes the purchase of up to 19% of total shares outstanding, this will increase the value of the stock to its shareholders. However, the dividends will remain constant.

3. Drawing on the financial ratios in case Exhibit 6, how much debt could Deluxe borrow at each rating level? What capitalization ratios would result from the borrowings implied by each rating category? (THIS PART IS MISSING AND NEED MORE INFORMATION CHECK THE SAMPLE PLEASE THEY HAVE MENTIONED STEPS)

There is a general concept that higher rating category will have the lowest cost of debt. But rating categories only give the information about the default risk and loss in case of company default. It does not guarantee the lowest cost of capital. For the lowest cost of capital we must need to analyse the WACC and we should select the category providing less WACC but the category must be at-least BBB.the company should maintain the its credit rating level because in this level the WACC is the smallest than other level and the amount of debt in this level is 586.06 million dollars.

DC can borrow up to $807.5 million. This is based on their three types of loans they can take out; commercial paper, line of credit and medium-term notes minus the amount of equity they access. The amount of debt they would access depends on the credit rating, the worse the credit rating, the less they will be able to borrow.

AAA

AA

A

BBB

BB

B

Remaining Equity

5.0%

35.9%

42.6%

47.0%

57.7%

75.1%

Amount of Debt that DC can borrow

95.0%

64.1%

57.4%

53.0%

42.3%

24.9%

D/E ratio

19.00

1.79

1.35

1.13

0.73

0.33

Amount of Debt that DC can borrow

$807.50

$544.85

$487.90

$450.50

$359.55

$211.65

4. Is Deluxe’s current debt level appropriate? Why or why not? (NOT ENOUGH INFORMATION PLEASE ADD MORE )

No, I do not think that the current level of debt for DC is appropriate. Just based on the foreseen financing that is due in the coming years, they do not have enough with their $161.5 million. They need additional funding. I also think that for this business to not just sustain the next five years, but to prosper after that time frame they will need to acquire their competition’s business, since it is likely their competition will go under before DC. This will take aggressive marketing, and strong sales. Based on their expenses, they may not have the resources to do so.

But based on the current state of the business, they could expect to be acquired by a electronic payment type of company like they had spun-off in eFunds. A company like this will want to tap into an established customer base, and they will be able to get a company like DC at a discount over the next couple years.

5. Using Hudson Bancorp’s estimates of the costs of debt and equity in case Exhibit 8, which rating category has the lowest overall cost of funds? Do you agree with Hudson Bancorp’s view that equity investors are indifferent to the increases in financial risk across the investment-grade debt categories?

WACC alone cannot give the optimal value for the shareholders; it only provides the minimum cost range. WACC and market value of the company move simultaneously and these two are the major determinant of rating category. Generally, as the market value increases, WACC starts to decline. In the process there will be one optimal level where the difference between WACC and market value will be maximum(Refer to the graph below);similarly level of debt-to-equity will be maximizing the shareholders value.

Therefore the company should not focus more on credit rating, rather it should concentrate on maximizing the shareholders value. By maintaining minimum WACC,company can get its range for optimal credit rating.

6. What should Singh recommend regarding:

· Target bond rating.

DC needs to position itself to obtain a AAA rating. Anything less can start a downward spiral for the company. If the shareholders start to sell, this company may not rebound since it is in a dying industry. Once it drops out of the premium ratings, the company will be an acquisition target by growing electronic payment companies.

· Level of flexibility.

Flexibility is the amount of debt DC can take on before you lose the investment-grade bond rating. Based on the financial analysis, the BB level is where the cost jumps the most. There is a 26% increase in costs from a level BBB rating to a level BB.

· Mix of debt and equity.

DC is targeting an aggressive share buyback plan. They are increasing their equity in the company by reducing shares. But because of the future of the company, they will also need to take on debt. Based on the financial analysis, they are better off taking on debt. Debt is cheaper for DC. Cost of debt ranges between 5.47% to 12%, and that does not even include the 37.5% tax shield. Cost of equity is more expensive, it ranges from 10.25% to 14.25%, and there is no tax shield.

· Other?

Today is six years after the case, and DC is still in business. The stock (DLX) has been very volatile. It looks like the CEO was correct, after five years, the revenue growth has stopped, and turned negative. The financials are starting to weaken, and the company has turned to diversifying its business to stay around.

P.S. These questions do require calculations but their accuracy is not critical. It will be enough to provide well explained opinions with supporting analysis.

Supporting Spreadsheet Files

To assist student preparation, a MS Excel File is made available to the students which contains several exhibits and a working forecast model. Students however may develop either their own model if they so desire or use the one provided.