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Deluxe Corporation Case Study Analysis In Education

Summary Deluxe Corporation is the dominant player in check-printing industry. In the past, its sales increased at a compound annual rate of 12% and occupied 49% market share in US. However, new forms of payments encroached on the demand of check-printing industry. The demand for printing check falls at 1% to 3% annually. The core business of Deluxe faces a big challenge. In the late summer, Singh, the retained by Deluxe’s board of directors was designated to submit a plan for the new round of debt issuing. It’s certain that someday in the future the company may struggle to survive. In order to deal with bad situation in the future, Deluxe must maintain financial flexibility and lower its cost of capital by changing into appropriate capital structure. There are three alternatives in this case. They are issuing bond at AA, A and BBB rating. And in each situation, we get the lowest WACC. In the implementation, we decide to issue bonds at rating BBB. Problem Statement Deluxe Corporation will face a big challenge for its core business which means that the company would struggle to survive in the future. There is a new round of issuing debt at hand which may help Deluxe to relieve some pressure for the future. This new debt could help increase financial flexibility and change capital structure which produces lowest cost of capital. So the key issue here is : what’s the best debt policy for Deluxe corporation?

Unformatted text preview: Deluxe Corporation Main Case Objectives Illustrate a simple practical method of estimating optimal capital structure (leverage) • Discuss the determinants of corporate bond ratings • Examine debt capacity and financial flexibility • Estimate the trade-offs between the benefits and costs of leverage General Case Setting: • Who is Rajat Singh? • What is his connection to Deluxe? Deluxe Corporation Background What is the nature of Deluxe’s business? How would you describe the firm’s strategy? What are the main concerns/risks? • Deluxe Corporation Key Financial Policies What are management’s key objectives in setting the firm’s financial policy? • Deluxe Corporation Future Funding Requirements Based on Exhibit 4, why might Deluxe have financing requirements in the coming years? Financial Flexibility How large is Deluxe’s “debt capacity” under each credit rating category? • What are the primary determinants of a bond rating? • • Credit Rating Key Ratios Credit Rating AAA AA A Investment Grade BBB 23.4 214.2 156.6 35.0 23.4 (1.1) 5.0 13.3 65.7 33.6 26.6 24.0 21.1 35.9 3.9 30.6 12.8 13.1 15.5 40.3 47.0 Key Industrial Financial Ratios (Three-year medians 2000–2002) EBIT interest coverage (x) Funds from operations/total debt (%) Free operating cash flow/total debt (%) Return on capital (%) Operating income/sales (%) Long-term debt/capital, book (%) Total debt/capital, book (%) 6.3 42.2 22.3 18.1 18.1 33.8 42.6 BB B Noninvestment Grade 2.2 19.7 7.3 11.5 15.4 53.6 57.7 1.0 10.4 1.5 8.0 14.7 72.6 75.1 Source of data: Standard & Poor's CreditStats, September 8, 2003. In the Deluxe analysis, we simplify by assuming the bond rating is determined solely by the EBIT coverage ratio Quantifying financial flexibility using coverage ratios Compute the debt level associated with each rating category, using… • • • EBIT coverage ratio for each rating from Exhibit 6 Pretax cost of debt (10-year) from Exhibit 9 Five-year average of EBIT as reported in Exhibit 4 (i.e. $359M) • • Using the market value of equity ($2,665M from exhibit 1), compute the implied capital structure for each rating category • Analysis of Financial Flexibility by Bond Rating Category($U.S.MM) Pretax cost of debt (case Exhibit 9) Required EBIT interest coverage (Exhibit 6) AAA AA A BBB BB B 5.51% 5.52% 5.70% 6.33% 9.01% 11.97% 23.4 13.3 6.3 3.9 2.2 1.0 $359 $359 $359 $359 $359 $359 Estimate of Debt Capacity Normalized 5-year EBIT (case Exhibit 4) Interest implied by rating $15 Debt implied by rating $3,004 Estimate of Capital Structure Deluxe Corp. market value of equity $2,665 $2,665 $2,665 $2,665 $2,665 $2,665 Debt implied by rating $279 $3,004 Total debt/capital implied by rating 9.5% 53.0% Estimate of Unused Debt Capacity Book value of existing debt $161 Debt implied by rating $279 $161 $161 $161 $161 $161 Estimating Deluxe’s WACC Using the weights from above, and Bancorp’s estimates (Exhibit 8), estimate the firm’s WACC for each rating category. Which rating category would produce the lowest WACC? Cost of Debt & Equity by Rating (using Bancorp’s Ke estimates) AAA AA A BBB BB B Cost of debt (pretax) 5.47% 5.50% 5.70% 6.30% 9.0% 12% After-tax cost of debt (38% tax rate) 3.39% 3.41% 3.53% 3.91% 5.58% 7.44% 10.25% 10.35% 10.50% 10.60% 12.00% 14.25% 5.00% 35.90% 42.60% 47.00% 57.70% 75.10% Cost of equity Weight of debt (from coverage ratio) Weight of equity WACC (using market weights) Debt/capital (book) (from Exhibit 6) An alternative approach: Use CAPM to estimate Ke (as in Bruner article on Learn) An alternative approach • • if not given costs of equity if want your own estimates unlever Deluxe’s beta in exhibit 1 relever β to the D/E ratio for each category calculate the CAPM cost of equity calculate WACC as above Calculation of Unlevered Beta (uses data in exhibits 1 and 3) Start with initial beta: Long term debt (exhibit 3) Short term debt (exhibit 3) Debt Equity D/E Initial Beta (levered) 11.5 150 161.5 2665.4 6.06% .85 Calculate unlevered (asset) beta: .85 Equity U (1 1 T D ) U (1 .62(.0606)) E U .82 Using CAPM to estimate Ke relever β to the D/E ratio for each category calculate the CAPM cost of equity (Rf = 5.3% (ex 9), MRP = 5.4%) calculate WACC Then Calculate the values in the table on the next slide… Cost of Debt & Equity by Rating Alternative Approach Based on CAPM and Levered Beta Unlevered beta Debt/equity (market) Relevered beta AAA AA A BBB BB B 0.82 0.82 0.82 0.82 0.82 0.82 5.58% 7.44% % 0.87 Cost of equity: (Rf = 0.053, RP = 0.054) After-tax cost of debt 11.22% 3.39% 3.41% 3.53% 3.91% Weight of debt % 53.0% Weight of equity % 47.0% WACC (market weights) 9.38% Debt/capital (book) 5.00% 35.90% 42.60% 47.00% 57.70% 75.10% WACC (book weights) 9.68% 7.78% 7.68% 7.78% 8.12% 8.78% Conclusion Do you think Deluxe Corporation’s current level of debt is appropriate? What financial policy should Rajat Singh recommend for Deluxe? Any issues/caveats with the analysis? • Deluxe’s debt rating was determined by which of the following? • EBIT coverage ratio • Debt capitalization ratio • Earnings coverage ratio • Long term debt / capital ratio • All of the above A firm is targeting a BBB debt rating (similar to Deluxe). BBB debt has an EBIT coverage ratio of 4, yielding 6%. If EBIT is $12MM, what is its target debt level? • $75 M • $50 M • $25 M • $10 M • $5 M ...
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