Case 35 deluxe corporation solution

Case 35: Deluxe Corporation

Spring Semester 2017 – 2018

Written By

Balqees Mekhlafi 1420231

Maryam Barifah 1420023

Nour Abdulaziz 1420149

Shrouq Al-Jaaidi 1420072

Submission Date

11/03/2018

Table of Contents Table of Contents 2 Synopsis 3 Introduction 4 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? 4 The risk associated with Deluxe’s business and strategy involves the following: 4 The financing requirements we foresee for the firm in the coming years are the following: 6 2. What are the main objectives of the financial policy that Rajat Singh must recommend to Deluxe Corporation’s board of directors? 8 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? 9 4. Is Deluxe’s current debt level appropriate? Why or why not? 9 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? 9 6. What should Singh recommend regarding: 10 The Target Bond Rating 10 The Level of Flexibility or Reserves 10 The mix of debt and equity 10 Table for 2001(Market Value) For the Maximum Debt Level 10 Table for 2001(Market Value) For the Minimum Debt Level 12 Other issues should be brought to the attention of the CEO and the board: 12 Conclusion 13

From 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
The Deluxe Corporation was considered to be the largest printer of paper checks in the United States of America, it was the dominant player in the highly concentrated and competitive check-printing industry. Recently the company retired all of its long-term debt and has not issued a major bond in around more than 10 years. Even though that Deluxe is a very mature company, the CEO Lawrence J. Mosener predictes a decrease in the demand of their product.

The objective in this case is to find and recommend an optimal and most appropriate financial policy for this corporation as well as to illustrate the impacts on the cost of capital, financial flexibility, and bond rating. Hence, what is required is for us to find and identify the risks that Deluxe is associated with, any and all financial requirements which are needed by the company, the objectives of the financial policy that Rajat Singh must recommend, the debt level and capitalization ratio, as well as the credit ratings based on S&P and Moody's rating agencies, concluding with a recommendation for the firm.

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?
The risk associated with Deluxe’s business and strategy involves the following:
· Deluxe Corporation was in the mature stage in the business life cycle, the CEO Lawrence J. Mosner still estimated that paper checks usage/demand is declining and customer’s preference are changing towards the more electronic based services. So the technological advancements which include Debit/ Credit cards, wire transfers, E-Funds, ATMs, and Internet bill paying systems. Business that operate in the check-printing industry have shown to have an annual decline of 1%-3% in check demand, it is also expected to have further decline in the future. So with this decline Deluxe has been facing challenges on its sales, earnings growth and all other growth opportunities.

· Check printing operates in a very highly concentrated market where there are only three main players who are controlling a total of 90% of the market. Deluxe mainly competes with John Harland and Clarke American companies, where Deluxe owns around 49% of the US check printing market share. Due to the very limited number of participants in this business market as it is usually works with big economies of scale, a large number of competition arises as these three companies have possible disagreements in pricing resulting is potential risk.

· Deluxe also faces business risk, as the compound annual rate of sales growth was around 4%, which shows that Deluxe was facing a decline in the market. Therefore, the company has decided that it would spin-off into the business of electronic payments with eFunds and iDLX technology partners to better diversify their core business. For them to mitigate this risk, Deluxe is faced with the urgency to adapt to the market needs and help financial institutions, as their major customers by providing them with other services than the check printing papers. In addition, cross sell a variety of products and services to Small Medium Enterprises (SMEs).

· Deluxe also faces liquidity and operational risk, this can be a result of the company’s uneven working capital from the years 1992-2001 where in 1992 it was at $330.9 million and in 2001 it was $116.6 million. The working capital rate is still in the positive so this means that they are able to pay their current liabilities, but this decline over the past 10 years might be considered risky, since in the future when they want to pay future current liabilities from future current assets.

· Debt coverage ratio which is calculated by Operating Profit/Debt (short and long term) it shows that Deluxe’s current debt level in 2001 which is approximately 302/161.5 = 1.869. So this number indicates that Deluxe is below the required level for any rating category.

· The company is also facing technological risk which is because the company is trying to become a pure play printing check company. The company should try to diversify their core business and capitalize on their strengths and the company shows also realize that the increase in technologies and e-commerce so the checking printing business is becoming obsolete.

· The company is also facing the risk that the capital market is unpredictable which means that there is a very large possibility of a rise in the cost of capital. So Rajat Singh must provide recommendations in regards to the capital structure at the earliest time possible.

· Deluxe’s 2001 price earnings ratio (P/E) was 11x which is below the market P/E ratio (29.5x) as the P/E ratio show how much investors might expect from their investment therefore the lower the ratio the less customers might be motivated to invest in the company.

The financing requirements we foresee for the firm in the coming years are the following:
· As electronic payment systems gain greater demand and preference from customer Deluxe faces increased competition. Therefore, the company will have large investment needs in order to keep up with the competition. An advantage of the tight asset management under the new CEO results in a reduction in costs hence improving cash flows.

· Deluxe is also facing an additional requirement for short-term financing needs for corporate purposes, such as capital asset purchases, working capital, repayment of outstanding debts, possible acquisitions, dividend payments, and repurchasing the firm's securities. For them to meet those needs, Deluxe could draw upon commercial paper, line of credit, and medium-term notes debt instruments. Moreover, in February 2001, Deluxe paid off $100 millions of its 8.55% long-term unsecured and unsubordinated notes, which it had issued in 1991.

· Ever since the decline in paper checks in 1990s, Deluxe conducted a major reorganization where it divested non-strategic businesses and cut down on their number of its employees and facilities, the company then went from 62 printing plants to 13, reduced its labor force from 15,000 to 7,000 (almost half), outsourced information technology functions, improved manufacturing efficiencies, and divested nearly 20 separate businesses.

· A stock repurchase program was approved by Deluxes board of directors in January 2001. By the end of that year, the company would have spent about $350 million to repurchase 11.3 million shares. In 1999, this program followed a share repurchase program, which called for the repurchase of about 12.5 % of the firm’s shares outstanding. Deluxe funded these repurchases with cash from operations and from issuances of commercial paper.

· Singh has also reviewed other possible demands on the firm’s resources where cash dividends will be held at a constant level for the foreseeable future. In addition, capital expenditure will be equal to depreciation for the next couple of years.

· In exhibit 4, Deluxe Corporation's financial forecast shows an increase in the free cash flows from 2002 ($212.2 million) till 2006 ($229.7 million). The cash as well increased to $625.4 million in 2006 compared to 2002 whereas the debt level stayed the same ($161.5 million).

· In the excel sheet, exhibit 4, Deluxe Corporation’s financial forecast shows an increase in the free cash flows from 2002 ($212.2 million) till 2006 ($229.7 million).

· Since deluxe is facing financial flexibility, having access to enough cash and debt at cheaper rates would be helpful.

· Deluxe could use a Strategic Acquisitions strategy, in which they acquire other firms such as their competitor in order to increase the value of their company which therefore increases shareholders perception of the company and further improve their satisfaction level.

· Deluxe could leverage their strengths to increase shareholder value, their strengths are being the market leaders as well as having a significant cost advantage.

2. What are the main objectives of the financial policy that Rajat Singh must recommend to Deluxe Corporation’s board of directors?
Rajat Singh believed that Deluxe’s financial policy would be able to help the company afford fund when it is needed in order for them to have flexibility and continue surviving. Therefore a recommendation by Singh to the board of directors of a new debt program and stock repurchase included the following main objectives:

· The main and most important objective is to maximize the value of the firm and maintain its financial flexibility for survivability.

· To provide an optimal capital structure (a mix of debt and equity) that maximizes shareholders’ value and makes it sustainable.

· Leverage their strengths and capabilities, which are being the market leader and their cost advantage in order to enhance shareholders value.

· To fend off the eventual disintegration of its core business. As the CEO does not want to let go of their core business too soon until they mine all they can out of it before.

· Come up with maximum and minimum amount of debt to achieve a desired rating.

· Maintain low cost of capital or increase debt to benefit from tax advantage.

· Maintain the current investment grade rating position and not deteriorate.

· Minimize Weighted Average Cost of Capital (WACC) in order to be able to raise funds at low cost.

· A financial policy that meets operating requirements.

· A feasible policy in order to implement it in present and future.

· Have reserves on hand to restructure further or for acquisitions if needed.

· Make Deluxe more on an attractive investment for potential investors so they are able to raise funds quickly in the future if needed.

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?
The key industrial financial ratios are shown in Exhibit 6 cateogorized by rating. The rating is split into two parts, Invest Grade; which includes AAA, AA, A, and BBB, and a Non-investment Grade/junk; which includes BB and B. The specialty of an investment grade rating is the ability to meet and service financial commitments from excellent to good capacity. This means that a company, in our case is Deluxe, could borrow a large amount of money, as they are rated well. However, they need to keep in mind the risks associated with the cost of borrowing these borrowings. Furthermore, a company with non-investment grade shows a company that they have speculative characteristics and are not able to meet their financial obligations; which in our case would limit Deluxe’s use of debt. Usually the lower the cost of debt, the higher the rating would be. These ratings, however, only give information that proves useful in case of a default.

What was done in the attached excel sheet (Exhibit Q3) for the answer and analysis (Keeping in mind the numbers are in million):

1) We first collected the Pre-tax cost of debt from exhibit 8 and the EBIT interest coverage from exhibit 6.

2) For us to estimate the maximum debt capacity, we used a 5-year average of the ebit from years 2002 and until 2006 from exhibit 4 which is equal to $359.42$359.

3) The Maximum interest implied by rating was calculated by dividing the 5-year average EBIT by the EBIT interest coverage.

4) Then, a calculation of the maximum amount of debt per rating was done by dividing the maximum interest implied by rating with the pre-tax cost of debt.

5) So now, in order to calculate the worse-case scenario, we used the two-sigma adverse outcome of an EBIT close to $200, which was derived from the case study.

6) Then, the minimum interest implied by rating was calculated in the same way as the maximum interest implied by rating. However, we substituted the 5-year EBIT average with the worst case scenario EBIT. This, too, goes for the minimum total debt implied by rating; however, we took the minimum interest accordingly.

7) Afterwards, we calculated the estimate of unused debt capacity to estimate how much more they could potentially borrow. First, we calculated the book value of Deluxe’s already existing debt by adding long-term debt, which was shown as $10.1, short-term debt, which was shown as $150, and current maturities of long-term debt of $1.4; totaling $161.5. Secondly, we calculated unused debt capacity at the current rating by the subtraction of maximum debt implied by rating with the book value. Finally, we calculated the unused debt capacity to the point of non-investment grade rating, BB by the subtraction of maximum debt implied of each rating category by the maximum debt implied by BB category.

8) Furthermore, in order to estimate the capital structure, we calculated the market value of equity by the multiplication of Deluxe’s corporation’s stock price with common shares outstanding at the end of the year. Which was driven from the year 2001 in exhibit 1.

9) Finally, in order to calculate the capitalization ratio, the total debt was divided by the market value of equity plus maximum debt implied by rating.

4. Is Deluxe’s current debt level appropriate? Why or why not?
Deluxe’s current debt level is not considered appropriate, as currently the company has a debt level of $161.5 million as shown in Exhibit 4 while they should actually have a minimum of $814 million. This deduction was done by calculating the company’s maximum and minimum debt level that it can afford taking for a detailed analysis. Which is done in the attached excel sheet Exhibit Q3 (for details on the calculation of each number) and the below table.

Estimate of Maximum Debt Capacity

AAA

AA

A

BB

BB

B

Maximum total debt per rating

$281

$491

$1,001

$1,463

$1,815

$2,995

Minimum total debt per rating

$156

$273

$557

$814

$1,010

$1,667

The target debt level that is chosen is the one minimizes cost of capital (WACC). When looking at the market value of equity, the lowest cost of capital which is 8.23% is achieved at the investment grade of BBB as seen by the calculation in Exhibit Q5.2 in the excel sheet. Where the optimum debt level is $814 million as shown in the above table. According to Rajat Singh, in the worse case scenario two-sigma adverse outcome of an EBIT was taken which should not be less than $200M and this is used to calculate the minimum debt level at the BBB rating. In addition, in the best case scenario, the maximum debt level is $1,463 at the BBB rating which was the rating the lowest WACC is found.

In conclusion, Deluxe has been underutilizing the capacity of their debt and hence can increase their debt ratio as the company has not achieve a minimum debt of $814M.

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?
In order to evaluate Deluxe corporations and analyze it we need to do the following:

· Take the projected free cash flows from Exhibit 4 from year 2002 till 2006.

· Terminal value is a representation of all future cash flow which are expected at the end of the year. This method is used to capture the value of a company beyond its projection period. Therefore we calculated it only for 2006 by multiplying the 2006 free cash flows taken Exhibit 4 by (1+Growth Rate)(WACC-Growth Rate) which gives a total of $3,139.6.

· By doing the above calculation we have estimated the value of the growth rate by seeing how much the net sales are changing from 2001 to 2006.

· For the WACC we calculated by taking the average of the market WACCs of AAA and B as estimated for its value (Exhibit Q5.1).

· For the calculation of the total free cash flow (FCF) we add the free cash flow from Exhibit 4 with the terminal value.

· For the discounted cash flow (DCF) we calculated the net present value by estimated WACC and the sum of the total free cash flows in all the projected years.

· The DCF analysis in Exhibit Q5.1 shows the intrinsic value per share is $40.88 (Equity divided by shares outstanding). This is compared to the 2001 recent year-end stock price which is $41.58 ($41.58-$40.88/$41.58) approximately 2% above the DCF estimate.

For a clearer understanding of what are costs of funds we will need to define it. It is actually the interest cost the financial institutions will pay to deploy funds they use into their business. So generally the higher the rating category, the lower the cost of debt will be, however, looking into exhibit 8 of Hudson Bancorp only will reflect the default risk and loss that may be encountered in the case of the company’s default. This calculation doesn’t show the lowest cost of funds, so in order to estimate it one will need to calculate the WACC as the lower the WACC goes, the lower the cost of funds will be, the common rule is that at least it needs to be a BBB rating category. In addition when calculating the WACC, the variables imported into it must be according to rating. Weighted Average Cost of Capital (WACC)= Wd x Rd x (1-T) + We x Re; this formula is used to calculate the WACC as seen on the excel sheet.

Therefore, only the WACC is what can be used to determine the cost of capital and the rule is to minimize that cost as much as possible while still maintaining at least a rating of Triple B, since the lower the WACC goes, the greater the enterprise value will be. The weighted average cost of capital (WACC) is the lowest rate of return that a firm must earn in order to remain at their break-even point. A firm should want its return to be considered greater than their WACC if not then they will be considered to be in deficit. However, the WACC by its self doesn’t provide shareholders optimal value as it only offers minimum cost. WACC has an inverse relation to market value, when the market value of a firm increases the WACC will decline but only to certain point and then it will rise. WACC and Market Value are the main elements of rating levels. All the detailed calculations are done in Exhibit Q5.2.

Based on Hudson Bancorp, the lowest WACC is for the BBB rating category at 8.23% using market weights and 7.45% using book weights. Using the market value of WACC is more appropriate than actually using the book value because investors would demand a rate of return on the market value of capital no on the book value. The company should not focus more on credit rating, rather it should concentrate on maximizing the shareholders value. By maintaining minimum WACC, they can get its range for optimal credit rating.

Yes, we agree with his point of view since equity investors will be indifferent to any increase in the financial risk across the investment-grade debt categories on the condition that it will remain within the rating category. One advantage is that the increases in debt has is that the tax rate implied on its providing a shield to equity investors, as these interests are considered tax deductible. Not only that, the cost of debt is decreased on the credit as the government pays part of that cost, resulting in an increase in the equity investors’ earnings and a rise in the overall value of the firm. Reducing furthermore, leverage with an equity issue will dilute the share price and sacrifice the benefits of debt tax shields. The firm’s commitment to share repurchases indicates a desire to maintain control. Funding will be required to support that strategy.

Nonetheless, interest rates are rising, as suggested by the comparative yield curves in case Exhibit 9. Depending on one’s long-term interest-rate outlook, one might want to sell more debt now (before rates rise further); alternatively, one might want to sell equity now (when it is somewhat overpriced) and wait to sell debt later when interest rates decline.

6. What should Singh recommend regarding:
The Target Bond Rating
After all the calculations and analysis of the overall bond ratings, Singh can now recommend to Deluxe a BBB (Triple B) rating as it is the rating that minimizes the WACC, so it is considered the most appropriate. The Triple B rating is considered an investment grade which is why it is in consideration and will be taken, the concept is that the lower the value of the WACC, the better the bond rating is.

The Level of Flexibility or Reserves
In order for Deluxe Corporation to create a sustainable competitive advantage and fit in with their environment; a certain level of flexibility should be determined. In case of debt, the level of flexibility is the amount of debt that Deluxe can take on before losing the investment-grade bond rating, in this case the rating BBB is from $814millions to $1463millions. For maximum level of debt it is $1463millions and for minimum level of debt it is 814 millions. So, the reserve for Deluxe Corporation is $649 ($1463- $814) millions.

The mix of debt and equity
In the area of the mix of debt and equity, Deluxe Corporation is targeting an aggressive program of share repurchases and buybacks. The is actually reducing shares, which in turn increases their equity. Deluxe Corporation will need to take debt because analysis shows that it will be cheaper for the company. The cost of debt ranges from 5.47% to 12% without the 38% tax shield being included. On the other hand, cost of equity is more expensive, since it ranges from 10.25% to 14.25% and here there is no tax shield. Where cost of debt after the tax change ranges from 3.39% to 7.44%.

Table for 2001(Market Value) For the Maximum Debt Level
2001(Market Value) For the Maximum Debt Level

AAA

AA

A

BBB

BB

B

Debt

$281

$491

$1,001

$1,463

$1,815

$2,995

Other long term liabilities

37.02

37.02

37.02

37.02

37.02

37.02

Equity

$2,665

$2,665

$2,665

$2,665

$2,665

$2,665

Total Capital

2983.02

3193.02

3703.02

4165.02

4517.02

5697.02

Debt Ratio

0.094

0.154

0.27

0.35

0.40

0.53

Equity Ratio

0.89

0.83

0.72

0.63

0.58

0.47

Under the Triple B (BBB) ratings, the mix of debt to equity for maximum level of dent is 0.35 to 0.63.

Table for 2001(Market Value) For the Minimum Debt Level
2001(Market Value) For the Minimum Debt Level

AAA

AA

A

BBB

BB

B

Debt

$156

$273

$557

$814

$1,010

$1,667

Other long term liabilities

37.02

37.02

37.02

37.02

37.02

37.02

Equity

$2,665

$2,665

$2,665

$2,665

$2,665

$2,665

Total Capital

2858.02

2975.02

3259.02

3516.02

3712.02

4369.02

Debt Ratio

0.055

0.092

0.171

0.232

0.272

0.382

Equity Ratio

0.932

0.896

0.818

0.76

0.72

0.61

Under the BBB rating, the mix of debt to equity is 0.232 to 0.76 for minimum level of debt.

Other issues should be brought to the attention of the CEO and the board:

We are of the belief that there are no other issues which must be brought forth to the attention of the CEO and board of directors that were not mentioned other than the recommendations of Bancorp that needs to be considered such as the mix of debt and equity and level of flexibility.

Conclusion
For Deluxe the bond rating would assume as default risk since the debt level is high which will lead to higher default risk and low credit rating. The corporation manages to construct the optimal value which will help structure the bond rating to achieve company’s goal of financial stability and higher profits.