Statement of the Problem

Rajat Singh, a managing director at Hudson Bancorp, needs to find a way to

rejuvenate the paper check corporation. One main part that needs to be
calculated is the appropriate mixture of debt and equity for the firm. The
company needs to determine the correct mixture so that they can both minimize
the cost of capital and increase the shareholders value. I will analyze the current
and future situation of the company, trying to find the correct credit rating to
use that will increase income. With the new credit rating, I will be able to
recommend a certain amount of debt for the company to take on and be
profitable. Facts and Assumptions
When trying to accurately calculate the cost of capital, the one main method
stands out the most. I had to calculate the WACC of the firm for the various
credit ratings. In order to accurately calculate this, I had to incorporate the
repurchase of shares and add the newfound debt to the total debt from 2001.
The project debt used by the corporation didnt factor in the repurchase of
shares and therefore it was calculated wrong.
To help me solve the equation for the best WACC, I had to make some basic
assumptions about the case. For starters, as shown in case, I decided to use a
37% tax rate like the analysts for Bancorp did because I felt that it would be
comparable to the numbers that they calculated in the projection. Next, I
decided to use the 5-year note yield because analysts provided information to
show that the market would mature after 5 years and paper checks would be
nonexistent.
Furthermore, I had to use the CAPM equation to figure out what my numbers
would be for the WACC equation. To show this, I used the equation: CAPM = Rf
+ (Rm-Rf)
Through the use of the case, I was able to assume a risk free rate of 3.45% while
I used 11.03% for the market risk premium and 0.85 and the beta. This led us to
the calculation of the cost of equity, which we could then use

. What are the risks associated with Deluxes business and strategy? Is Deluxes current
debt level appropriate?
Deluxe Corporation was once the largest printer of paper checks in the United States.
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. Some of the risk Deluxe Corporation is facing are:

* Online payment methods that improve along with the Internet, which is almost accessible
to everyone, everywhere. The popularity of paper check payments has decline versus this
online services. To add to this, the increase on the use of credit and debit cards are rapidly
taking market share from the print checks industry. * The increase on the use of credit ,
debit cards and ATMs, which have taking market share from the print checks industry. *
There is a decline of around 1-3% on the demand of paper checks; and Singh expects a
precipitously decline.
Deluxe current debt level is approximately 1.86997. This number was calculated with the
debt coverage ratio (operating income/debt service) and shows that Deluxe is below the
level required for any rating category.
2. What financing requirements do you foresee for the firm in the coming years? In order to
prevent the competition from online payments and credit/debit cards, Deluxe will probably
produce large investments and concentrate more in the paper-check industry for financial
services, business services and direct people (p.491). Moreover, costs will be reduced by
reducing the number of employees and facilities and divesting the organization (eFunds and
IDLX Technology Partners.) According to exhibit 4, during the upcoming years sales and
cash will probably increase around 1-2%. Debt, on the other hand, will be constant (161.5),
but total capital will increase from 277.2 in 2001 to...
In July 2002, an investment banker advising Deluxe Corporation must prepare
recommendations for the companys board of directors regarding the firms 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 firms 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 firms cost of capital, financial flexibility (i.e.,
unused debt capacity), bond rating, and other considerations. 1) What are the risks
associated with Deluxes 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 managements motivations and key objectives in setting the firms 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...

. What are the risks associated with Deluxes business and strategy. What financing
requirements do you foresee for the firm in the coming years?
Risks Associated with Deluxe s Business Strategy:
Firm had gone quite far in terms of share repurchase, now they only had an option of debt
financing
The check printing business was down and they did diversify from their core business but they
did not do away with core business.
Reorganization was done to reduce the operating expenses though the revenue growth kept falling
Deluxe 2001 P/E ratio was 11.x which was much below the market P/E of 29.5
The other risks are the fact that this is a matured market that is characterized by intense price
competition. There is also growth in electronic payments which pauses a risk. Consolidation of
banking sector will adversely impact the market of paper checks.
Working capital turns results in reduction of net working capital in the first year and increases
subsequently. Both of these require a tight asset management.
Financing Requirements that we foresee
Working capital
Capital asset repurchases
Acquisitions
Repayment of outstanding debts
Payment of dividends should be held constant for a foreseeable future.
Securities repurchase

2. What are the main objectives of the financial policy that Rajat singh must recommend to
deluxe corporations board of directors

Rajat Singh, a managing director at Hudson Bancorp, needs to find a way to rejuvenate the
Deluxe Corporation. One main part that needs to be calculated is the appropriate mixture of debt
and equity for the firm. The company needs to determine the correct mixture so that they can
both minimize the cost of capital and increase the shareholder value.
He would analyze the current and future situation of the company, 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 company to take on and be profitable. Rajat Singh
need to come up with minimum and maximum amount of debt that Deluxe can possibly afford to
achieve the desired rating.
Come up with minimum and maximum amount of debt for Deluxe to
achieve desired rating
Target bond rating should maintain reasonable reserves against
Deluxes worst case scenario
Policy should focus on a rating leading to low cost of capital
Policy should be feasible to implement in present and future.
Balance Deluxes goals of value creation, flexibility and bond rating
Low cost and continued access to capital under variety of operating
scenarios for the options considered by Deluxe.
Using Hudson Bancorps 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 Bacorps view that
equity investors are indifferent to the increases in financial risk across the investment-grade debt
categories?

Answer:

The rating category that has the lowest overall cost of funds is AAA. This is due to the fact that
the cost of debt is lowest (5.47%) in AAA and the cost of equity is also lowest (10.25%) at AAA.
The lowest overall cost of funds will be the

WACC= %age of equity x cost of equity + % age debt x cost of debt.

We agree with Hudson Bancorp view that equity investors are indifferent to the financial risk
across the investment grade debt categories.
Need some more explanation

QUESTION 5 Is Deluxe current debt level appropriate? Why or why not?

Clearly, Deluxe's current level of debt does not seem appropriate.
Refering to exhibit 4, the company is currently utilizing debt of $161.50 million. We have tried
to calculate maximum and minimum level of debt the company can afford to take. The summary
of maximum and minimum debt Deluxe can borrow at each rating category is shown below.
AAA
AA
A
BBB
BB
Maximum
Debt

240.79

421.33

856.26

1,254.38

1,556.57

2,568.33

Minimum
Debt

156.25

273.41

556.95

814.00

1,010.10

1,666.67

Maximum level of debt Deluxe can borrow at each rating category is derived in answer no.3
and4. The target debt level must be the one that minimizes the cost of capital. Considering
marketvalue of equity, minimum WACC is obtained at BBB. The optimum debt level for Deluxe
wouldbe $1254.38 million with the debt equity ratio of 33:67.
Now considering the worst case scenario, according to Mr. Singh, EBIT shall not be less
than$200 million. Again the minimum WACC is maintained at investment grade of BBB.
Theoptimum debt level for Deluxe would be $814 million with the debt equity ratio of 24:76.

refer to last table

So we may conclude that Deluxe Corporation has been underutilizing its debt
capacity. Thecompany has not yet achieved a minimum debt of $814 million. It can easily
increase debt ratioand still maintain the investment grade.

2001(Market Value)AAA AA A BBB BB B

Debt 240.79 421.33 858.26 1,254.38 1,556.57 2,568.33 Other long
termliabilities 37.02 37.02 37.02 37.02 37.02 37.02 Equity
2,665.36 2,665.36 2,665.36 2,665.36 2,665.36 2,665.36 Total Capital
2,943.16 3,123.71 3,560.64 3,956.75 4,258.94 5,270.71
Debt Ratio 0.09 0.15 0.25 0.33 0.37 0.49 Equity Ratio 0.91 0.85 0.75 0.67 0.63 0.51
Cost of capital 9.61% 9.34% 8.76%
8.44%
9.63% 10.94%