Capital Structure and leverage
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.
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.
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?
2. What are the main objectives of the financial policy that Rajat Singh must recommend to Deluxe Corporation’s board of directors?
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?
4. Is Deluxe’s current debt level appropriate? Why or why not?
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?
6. What should Singh recommend regarding:
· the target bond rating
· the level of flexibility or reserves
· the mix of debt and equity
· any other issues you believe should be brought to the attention of the CEO and the board
P.S. These questions do require calculations but their accuracy is not critical. It will be enough to provide well explained opinions with supporting analysis.
Supporting Spreadsheet Files
To assist student preparation, a MS Excel File is made available to the students which contains several exhibits and a working forecast model. Students however may develop either their own model if they so desire or use the one provided.