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Statement of the Problem Rajat Singh, a managing director at Hudson Bancorp, needs to nd a way to rejuvenate the paper check corporation !ne main part that needs to be calculated is the appropriate mi"ture of debt and e#uity for the rm $he company needs to determine the correct mi"ture so that they can both minimi%e the cost of capital and increase the shareholders value & will analy%e the current and future situation of the company, trying to nd the correct credit rating to use that will increase income 'ith the new credit rating, & will be able to recommend a certain amount of debt for the company to take on and be protable (acts and )ssumptions 'hen trying to accurately calculate the cost of capital, the one main method stands out the most & had to calculate the ') ')** ** of the rm for the various credit ratings &n order to accurately calculate this, & had to incorporate the repurchase repur chase of shares and add the newfound debt to the total debt from +- $he project debt used by the the corporation didn.t factor in the repurchase repurchase of shares and therefore it was calculated wrong $o help me solve the e#uation for the best ')**, $o ')**, & had to make make some basic assumptions about the case (or starters, as shown in case, & decided to use a /01 ta" rate like the analysts for Bancorp did because & felt that it would be comparable to the numbers that they calculated in the projection 2e"t, & decided to use the 34year note yield because analysts provided information to show that the market would mature after 3 years and paper checks would be none"istent (urthermore, & had to use the *)P5 e#uation to gure out what my numbers would be for the ')** e#uation $o show this, & used the e#uation6 *)P5 7 Rf 8 9Rm4Rf: ; $hrough the use of the case, case, & was able to assume a risk free free rate of /<31 while & used --/1 for the market risk premium and =3 and the beta $his led us to the calculation of the cost of e#uity, which we could then use
. What are the risks associated with Deluxe’s business and strategy? Is Deluxe’s current debt level appropriate? Deluxe Corporation was once the largest la rgest printer of paper checks in the United tates. !owever" around the past years it started to face difficulties pri#arily on its sale and earnings growth pri#arily because of alternative pay#ents syste#s as online pay#ents" credit and debit cards" etc. o#e of the risk Deluxe Corporation is facing are$
% &nline pay#ent #ethods that i#prove along with the Internet" which is al#ost accessible to everyone" everywhere. 'he popularity of paper check pay#ents has decline versus this online services. 'o add to this" the increase on the use of credit and debit cards are rapidly taking #arket share fro# the print checks industry. % 'he increase on the use of credit " debit cards and (')s" which have taking #arket share fro# the print checks industry. % 'here is a decline of around *+,- on the de#and of paper checks and ingh expects a precipitously decline. Deluxe current debt level is approxi#ately *./0112. 'his nu#ber was calculated with the debt coverage ratio 3operating inco#e4debt service5 and shows that Deluxe is below the level re6uired for any rating category. 7. What financing re6uire#ents do you foresee for the fir# in the co#ing years? In o rder to prevent the co#petition fro# online pay#ents and credit4debit cards" Deluxe will probably produce large invest#ents and concentrate #ore in the p aper+check industry for financial services" business services and direct people 3p.81*5. )oreover" costs will be reduced b y reducing the nu#ber of e#ployees and facilities and divesting the organi9ation 3e:unds and ID;< 'echnology =artners.5 (ccording to exhibit 8" during the upco#ing years sales and cash will probably increase around *+7-. Debt" on the other hand" will be constant 3*0*.>5" but total capital will increase fro# 722.7 in 7* to... In @uly 77" an invest#ent banker advising Deluxe Corporation #ust prepare reco##endations for the co#pany’s board of directors regarding the fir#’s financial policy. o#e special considerations are the #ix of debt and e6uity" #aintenance of financial flexibility" and the preservation of an invest#ent+grade bond rating. Co#plicating the assess#ent are low growth and technological obsolescence in the fir#’s core business. 'he purpose is to reco##end an appropriate financial policy for the fir# and" in support of that reco##endation" to show the i#pact on the fir#’s cost of capital" financial flexibility 3i.e." unused debt capacity5" bond rating" and other considerations. *5 What are the risks associated with Deluxe’s business and strategy? Deluxe corporation was once the largest printer of paper checks in the U. !owever" around the past years it started to face difficulties pri#arily on its sale and earnings growth pri#arily because of alternative pay#ents syste#s as online pay#ents" credit and debit cards" etc. Aisk facing$ &nline pay#ent #ethod that i#prove along with internet" and the use of credit and debit cards are gradually taking #arket share fro# the print checks industry Increase use of credit" debt cards and (') Deluxe current debt level is approxi#ately *./2. 'his nu#ber is below the level re6uire for any rating category. 'he nu#ber is the debt coverage ratio 3operating inco#e4debt service5 'his is the a#ount of cash flow available to #eet annual interest and principal pay#ents on debt. Bou want this nu#ber to be above *. What financing re6uire#ents do you foresee for the fir# in the co#ing years?
75 %%What are #anage#ent’s #otivations and key obectives in setting the fir#’s financial policy? ,5 Drawing on the financial ratios in case xhibit 0" how #uch debt could D eluxe borrow at each rating level? What capitali9ation ratios would result fro# the borrowings i#plied by each rating...
. What are the risks associated with Deluxe’s business and strategy. What financing requirements do you foresee for the firm in the coming years? Risks Associated with Deluxe’ s Business trategy! "irm had gone quite far in terms of share re#urchase$ now they only had an o#tion of debt financing %he check #rinting business was down and they did di&ersify from their core business but they did not do away with core business. Reorgani'ation was done to reduce the o#erating ex#enses though the re&enue growth ke#t falling Deluxe ())* +,- ratio was **.x which was much below the market +,- of (./ %he other risks are the fact that this is a matured market that is characteri'ed by intense #rice com#etition. %here is also growth in electronic #ayments which #auses a risk. 0onsolidation of banking sector will ad&ersely im#act the market of #a#er checks. Working ca#ital turns results in reduction of net working ca#ital in the first year and increases subsequently. Both of these require a tight asset management. "inancing Requirements that we foresee Working ca#ital 0a#ital asset re#urchases Acquisitions Re#ayment of outstanding debts +ayment of di&idends should be held constant for a foreseeable future. ecurities’ re#urchase
(. What are the main ob1ecti&es of the financial #olicy that Ra1at singh must recommend to deluxe cor#oration’s board of directors
Ra1at ingh$ a managing director at 2udson Bancor#$ needs to find a way to re1u&enate the Deluxe 0or#oration. 3ne main #art that needs to be calculated is the a##ro#riate mixture of debt and equity for the firm. %he com#any needs to determine the correct mixture so that they can both minimi'e the cost of ca#ital and increase the shareholder &alue. 2e would analy'e the current and future situation of the com#any$ trying to find the correct credit rating to use that will increase income. With the new credit rating$ he will be able to recommend a certain amount of debt for the com#any to take on and be #rofitable. Ra1at ingh need to come u# with minimum and maximum amount of debt that Deluxe can #ossibly afford to achie&e the desired rating. •€€€€€€€€ 0ome
u# with minimum and maximum amount of debt for Deluxe to achie&e desired rating •€€€€€€€€ %arget
bond rating should maintain reasonable reser&es against Deluxe’s worst case scenario •€€€€€€€€ +olicy
should focus on a rating leading to low cost of ca#ital
•€€€€€€€€ +olicy
should be feasible to im#lement in #resent and future.
•€€€€€€€€ Balance
Deluxe’s goals of &alue creation$ flexibility and bond rating
•€€€€€€€€ 4ow
cost and continued access to ca#ital under &ariety of o#erating scenarios for the o#tions considered by Deluxe. 5sing 2udson Bancor#’s estimates of the costs of debt and equity in case exhibit 6$ which rating category has the lowest o&erall cost of funds? Do you agree with 2udson Bacor#’s &iew that equity in&estors are indifferent to the increases in financial risk across the in&estment7grade debt categories?
Answer!
%he rating category that has the lowest o&erall cost of funds is AAA. %his is due to the fact that the cost of debt is lowest 8/.9:;< in AAA and the cost of equity is also lowest 8*).(/;< at AAA. %he lowest o&erall cost of funds will be the
WA00= ;age of equity x cost of equity > ; age debt x cost of debt.
We agree with 2udson Bancor# &iew that equity in&estors are indifferent to the financial risk across the in&estment grade debt categories. eed some more ex#lanation
QUESTION 5 Is Deluxe current debt level appropriate? Why or hy not?
0learly$ Deluxe@s current le&el of debt does not seem a##ro#riate. Refering to exhibit 9$ the com#any is currently utili'ing debt of **./) million. We ha&e tried to calculate maximum and minimum le&el of debt the com#any can afford to take. %he summary of maximum and minimum debt Deluxe can borrow at each rating category is shown below. AAA AA A BBB BB Caximum Debt
(9).:
9(*.
6/.(
*$(/9.6
*$//./:
($/6.
Cinimum Debt
*/.(/
(:.9*
//./
6*9.))
*$)*).*)
*$.:
Caximum le&el of debt Deluxe can borrow at each rating category is deri&ed in answer no. and9. %he target debt le&el must be the one that minimi'es the cost of ca#ital. 0onsidering market&alue of equity$ minimum WA00 is obtained at BBB. %he o#timum debt le&el for Deluxe wouldbe *(/9.6 million with the debt equity ratio of !:. ow considering the worst case scenario$ according to Cr. ingh$ -BE% shall not be less than()) million. Again the minimum WA00 is maintained at in&estment grade of BBB. %heo#timum debt le&el for Deluxe would be 6*9 million with the debt equity ratio of (9!:.
refer to last table
o we may conclude that Deluxe 0or#oration has been underutili'ing its debt ca#acity. %hecom#any has not yet achie&ed a minimum debt of 6*9 million. Et can easily increase debt ratioand still maintain the in&estment grade.