Advance Questions for Case 10: Deluxe Corporation 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 purpose is to recommend an appropriate financial policy for the firm and, in support of that recommendation, to show the impact on the firm’s cost of capital, financial flexibility (i.e., unused debt capacity), bond rating, and other considerations. 1) What are the risks associated with Deluxe’s business and strategy? Deluxe corporation was once the largest printer of paper checks in the US. However, around the past years it started to face difficulties primarily on its sale and earnings growth primarily because of alternative payments systems as online payments, credit and debit cards, etc. Risk facing:
Online payment method that improve along with internet, and the use of credit and debit cards are gradually taking market share from the print checks industry Increase use of credit, debt cards and ATM
Deluxe current debt level is approximately 1.87. This number is below the level require for any rating category. The number is the debt coverage ratio (operating income/debt service) This is the amount of cash flow available to meet annual interest and principal payments on debt. You want this number to be above 1. What financing requirements do you foresee for the firm in the coming years?
2) **What are management’s motivations and key objectives in setting the firm’s financial policy? 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? a. Normalized 5-year EBIT is the average of EBIT forecasted over 2002-2006 in case Exhibit 4 b. Downside EBIT is estimated by Rajat Singh in the case text as $200 million c. Book value of debt in 2001 is listed in case Exhibit 3, and is comprised of long-term debt ($10.1 million), short-term debt ($150.0 million) and current maturities of long-term debt ($1.4 million) d. Market value of equity in 2001 is estimated as the year-end share price, $41.58 times the number of shares outstanding, 64,102,000 (see case Exhibit 1) 4) 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? 5) Do you think Deluxe’s current debt level is appropriate? Why or why not? 6) What would you recommend regarding:
the target bond rating the level of flexibility or reserves the mix of debt and equity any other issues that you believe should be brought to the attention of the CEO and the board