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Feb 20, 2024

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Deluxe corporation Executive summary KIRAN NAGARATNAM SKAND MITTAL

Frame the Key Issues and Decisions Deluxe Corporation is the largest printer of paper cheques in the United States. Their core business has been experiencing a decline in sales revenue due to the growing maturity of the market for paper cheques in the United States coupled with a shift towards electronic forms of payments such as ATMs, credit cards, debit cards, and the Internet bill-paying systems. Taking on the role of Rajat Singh, the goal is to recommend an optimal capital structure for the corporation that will maximize shareholder value and aid in their share repurchasing attempts through a reliable WACC estimate. This recommendation must also factor in flexibility, bond rating, value creation, and Deluxe low costs, and continued access to capital. Recommending a financial policy that balances these goals is crucial to the financial sustainability of the firm. Alternatives When computing the firm’s WACC, there are two viable alternatives to consider. The first alternative is to compute WACC using Bancorp’s estimates for Deluxe and the second a lternative is to estimate the cost of equity using CAPM which will then replace Bancorp ’s cost of equity estimate in the WACC computation. The debt ratios will be adjusted accordingly in each of the various scenarios. Under each alternative, the key elements of WACC must be scrutinized for their reliability and accuracy as the final WACC estimate plays a crucial role in determining the amount of debt to an issue, what grade of investment to maintain, and the final recommendation of the financial policy. Another set of alternatives to consider is whether to issue long-term financing or short-term financing. Some key considerations include their abilities to meet short-term debt obligations, the amount of access to short-term capital, and the cost of financing under both alternatives. This alternative will play an imperative role in Deluxe’s capital structure, WACC computation, and financial policy. Qualitative One of the main concerns for Rajat and the board of directors is optimizing the capital structure while retaining the current bond ratings while still managing to lower the cost of capital. According to the CEO, a good bond rating will not only save the interest payments but will also define D eluxe’s brand value. Bond ratings are currently evaluated by third party rating agencies (Standard and Poor, M oody’s in case of deluxe). This rating helps investors to understand a company’s liquidity position. Deluxe currently has an investment-grade bond rating of A. The financial team is looking to stay in this slot while maximizing the debt capacity to fund the working capital needs as the company is looking to make changes in its business model. What this essentially means is raising capital through debt to the point where the debt rating goes to BBB. This would ensure that the company still stays in an investment-grade bond slot. According to the projections performed by the analyst (exhibit 4), the sales are expected to grow annually by 0.2% due to the structural changes done recently by laying off employees and saving on fixed costs. This growth fuels working capital growth for the future. One of the other concerns is to avoid the debt overhang problem. Deluxe has a debt to value ratio of 33.97% which is in line with its brand value. Quantitative To fund its operations, Deluxe needs a total debt capacity of 960 million. This is calculated by dividing the interest implied of $55 million by the pre-tax cost of debt at the current A bond rating. The implied interest is calculated by dividing the expected EBIT by the target EBIT interest coverage. The required debt can be obtained by one of the two alternatives, short term or long- term financing. Talking about the short-term financing options, Deluxe corporation has used a mix of commercial paper and line of credit to fund its operations in the past. However, short financing

is inadequate to fund the long-term plan of the company. The maximum funds from the short-term options add up to $850 million, $150 million from commercial paper, $300 million from medium- term notes, and the rest from the committed and uncommitted line of credit. Furthermore, Deluxe ’s ability to meet their short-term obligation seems to below which is evident through their 2001 current ratio which is sitting at 0.23. The second alternative is using a long-term financing approach, there are two main calculations involved when it comes to long term financing option, the first being WACC calculation using Bancorp’s estimates. The WACC comes to 8.13% when using the Bancorp's pre-tax Kd and Ke at a 38% tax rate and an A bond rating estimates. Looking at the sensitivity analysis at A bond rating, we see quite a lot of fluctuations when it comes to changes in EBIT. Even though the WAC does not have significant changes from EBIT, the equity gains fluctuate significantly at different EBIT levels. The company even realizes a loss when the EBIT goes under 300 million. Therefore, the company needs to retain 350 million or higher EBIT to retain its gains. The second approach to WACC calculation involves the use of the CAPM model. This method gives a higher WACC of 12.5% at an A bond rating. This is because of a higher cost of equity for deluxe. This means that the WACC for Deluxe increases at a lower credit rating. This is because a lower rating comes with higher risk and therefore more returns for investors. This WACC is calculated using a market risk premium of 4.46% and an equity beta of 6.60%. One thing to note is that this WACC is calculated after the share repurchase has taken place and has therefore considered all aspects of a buyback. Another thing to note is that the changes in this WACC with a lower investment grade. The WACC increases to 9.5% and 10.4% at a BBB and BB rating. Recommendation After conducting a thorough quantitative and qualitative analysis on each of the alternatives, we believe that Deluxe should pursue long-term financing and replace Bancorp’s cost of equity estimate with CAPM as it will provide a more accurate WACC estimate. As outlined above, Deluxe will run into problems with meeting short-term obligations and cannot draw enough capital from these sources to meet their financial policy. Furthermore, Bancorp’s cost of equity estimate is derived from Deluxe ’s bond ratings and do not proportionately reflect the increased risk to equity from higher debt levels. Thus, computing the cost of equity through CAPM eliminates this error. Given that long-term financing is pursued and WACC is computed using CAPM Ke estimates, the optimal capital structure is attained at a debt/equity ratio of 51.44% or a debt-to-value ratio of approximately 34% as depicted in the exhibit 1. This capital structure will have the lowest cost of capital and will be within an A grade investment. It will also allow for ample flexibility depicted through the remaining debt capacity before the bond reaches non-investment grade, value creation through gain in equity from recapitalization, and maintaining invest grade securities. This recommendation balances the goals outlined in the opening paragraph and proves to be an effective policy. Assuming EBIT forecasts are accurate, a sound financial policy can easily be implemented, however, if EBIT deviates from projected forecasts significantly in a negative manner, there will be a plethora of financial implications for Deluxe. With EBIT at $200 000 when issuing investment-grade A debt, Deluxe will experience an increase in WACC and a loss to equity from recapitalization as depicted in the exhibit 4. This scenario may give rise to a debt-overhang problem as too much debt has been taken out relative to their EBIT and may cause a limitation in borrowing debt in the future and adhering to their financial policy. There lies uncertainty surrounding the forecast of EBIT which is a determining factor of their financial policy.

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