Deluxe Corporation Case Study
Corporation management is endorsed with the task of increasing the company value in relation to its shareholders. The company should perform all its operations in accordance with applicable responsibilities and laws. Company management is supposed to provide the board with valid recommendations on why some method of increasing the company value has been chosen over the other. For example, the management should explain why debt method of financing has been chosen over other available methods of financing. Company management also bears responsibility for all the risks associated with failure to choose effective method. In this regard, Rajat Singh, Deluxe Corporation advisor is considered to be one of the most skilled professionals in the field.
Deluxe Corporation is a check printing company that is rated among the largest check printing companies in the US. Deluxe controlled almost half of the check market in the 1970s – 1990’s when the check market was not complex and newer technologies had not yet emerged. The company was founded in Minnesota and in 1965 it became a publicly traded company. Most of its past was characterized by conservative financial approaches whereby stock repurchase program was the main financial method. Consequently, the company would retire all of its long-term debt by concentrating on the repurchasing programs.
As seen earlier, the company had been successful when the market was not complex and when checks were the most preferred payment modes. However, things change as increased technology changed the market. Online bill paying along with the use of credit and debit cards dominate the market of today. As a result, demand for paper checks started declining. Since the company management was alerted on this issue, they came up with few strategies aimed at cutting down costs. The company reduced the number of its employees by half. However, the company investors hailed what the management heard done in 2001 since the company increased its share prices. Therefore, the main issue was to lower the cost of capital at the lowest debt possible. This, however, would be done while considering the bond rating since the company still wanted to keep their desired bond rating.
Therefore, the main goal of the management was to decrease the cost of capital. This would only be done by bringing on some debt. However, the bond rating had to be maintained in order to keep the company investment grade. Being authorized by the board to come up with the best strategy, Rajat Singh must indorse the best way that value will be created for the shareholders through combination of equity and capital of debt. The important thing, is to obtain the bond with the highest rating while still paying as little as it is possible and getting the highest return on capital.
Bringing in some debt in order to decrease the cost of capital since debt itself is tax deductible. For example, when the company obtains a debt of 50 million, the government will not tax this. However, when the company obtains cash using other means than debt, it is to pay tax. A closer look at the company capital structure shows that its current debt is not appropriate because the company has not maximized its potential in exploiting this debt. The current debt, according to Exhibit 4, is at $161.50 million, which is very low. During the worst scenario, the company should at least have debt of 200million as provided by the calculations of the maximum and the minimum debt.
The appropriate bond to be used in this case is the bond with the five year maturity since it won’t take long for the company to reach the minimum debt during the worst case scenario.
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The best bond according to the calculations will be the BBB bond, because their cost of debt is 3.969% and cost of equity is 10.6%. Therefore, the debt equity ratio at the BBB bond is 37:63. Compared with other bonds, it is the most optimal bond to take. For example, the AAA bond, which could have been an option with its cost of debt esteemed at 3.4461% and the cost of equity being 10.25%. Therefore, the debt equity ratio for AAA is 33:67, which is a bit lower when compared with the debt equity ratio for BBB bond. Other bonds in the same category as AAA is the AA bond and the A bond meaning that the two cannot also be considered as choice for optimal capital structure.
On the other hand, other bond that could have been considered still has a high or an exaggerated debt equity ratio, which can lead the company to insolvency. For example, the cost of debt for the B bond is 7.56% and cost of equity is at 14.25%. The bond debt equity ratio is 53:47, which still poses risks to the company because it is higher. BB bond can also be considered an option though it being high. The above information is shown in the figure below.
Calculation of the optimal bond for Deluxe Corporation
|Cost of Debt||5.47||5.5||5.7||6.3||9.0||12.0|
|Cost of debt (after tax)||3.4461||3.465||3.591||3.969||5.67||7.56|
|Cost of Equity||10.25||10/35||10.5||10.6||12||14.25|
|Debt Equity Ratio (in decimal)||0.33||0.33||0.34||0.37||0.47||0.53|
|Debt Equity Ratio||33:67||33:67||34:66||37:63||47:53||53:47|
As seen earlier, during the worst scenario, the company should at least have debt of 200million. While this is the minimum debt, the maximum debt the company takes is $1274 million. These figures can still be obtained by first calculating the optimal debt capacity. Given that the EBIT in Exhibit 4 is 302 and the EBIT interest coverage ratio in Exhibit for BBB is 3.9. Therefore, the interest capacity is 77.43, which is calculated by dividing the EBIT with the EBIT interest coverage ratio. Using the 5 maturity bond shown in Exhibit 9, the interest rate is 3.45. This interest rate is used to calculate the debt capacity as shown below:
EBIT Interest Coverage Ratio=23.4
Interest Capacity= EBIT/ the EBIT interest coverage ratio=77.43
The Interest rate=3.45
Debt Capacity=Interest Capacity/Interest rate=22.45
The maximum debt is obtained by +or – (debt capacity multiplied by EBIT)
To emphasize on the best bond among the listed bonds, the Weighted Average Cost of Capital can be used. WACC is calculated by first obtaining the Weighted Average Cost of Debt and the Weighted Average of Equity. The Weighted Average is obtained in the capital structure by getting the total debt against the total equity
Weighted Average percentage= (Total Debt/Total Shareholder’s Equity) multiplied by 100
Therefore, Weighted Average for debt is 85%.
Weighted Average of Equity using the formula above is 15%
Weighing the value of bonds using the above Weighted Averages gives us the Weighted Average Cost of Equity and Weighted Average cost of debt for each bond. Weighted Average Cost of Capital, therefore, equals to the summation of the Weighted Average Cost of Debt and the Weighted Average Cost of Equity.
As seen earlier, the optimal bond was BBB. Testing the bond using the Weighted Average Cost of Capital brings a result of 4.96, which compared to other bonds is neither lower nor higher. Therefore, the BBB bond poses less risk and at the same time maximizes the debt capacity. Therefore, the company should use the BBB bond to maximize its potential.
Proving this using other bonds shows that the WACC is 4.46 for AAA bond, which is lower while the WACC for B is 8.57, which is too high as seen in the calculations below.
The Weighted Average Cost of Capital
|Cost of Debt||3.4461||3.465||3.591||3.969||5.67||7.56|
|Cost of Equity||10.25||10.35||10.5||10.6||12||14.25|
|Weighted Average Cost of Debt||2.93||2.95||3.05||3.37||4.1||6.43|
|Weighted Average Cost of Equity||1.5375||1.5525||1.575||1.59||1.8||2.14|
|Weighted Average Cost of Capital||4.4675||4.5025||4.625||4.96||5.9||8.57|
In conclusion, current problems in Deluxe Corporation can be solved by bringing in a debt as a way of decreasing the cost of capital. However, the company has to maintain the bond rating so as to keep the company investment grade. Based on the calculations, the best bond to take is BBB bond since the cost of debt is 3.969% and cost of equity is 10.6%. Therefore, the debt equity ratio at the BBB bond is 37:63. Compared with other bonds, this is the most optimal bond to take. The company should add to its debt because it has not maximized its potential in exploiting the debt. As mentioned above, the current debt according to Exhibit 4 is at $161.50 million, which is very low. During the worst scenario, the company should at least have debt of $200million.