Case 35: Deluxe Corporation

Instructor: John Robinson (Fin 790)

Group Member: Hongjian Gong (Vicky)

Yizhou Li

Michael Cao

Ya Zhou
Summary

Deluxe Corporation is the dominant player in check-printing industry. In the past, its sales

increased at a compound annual rate of 12% and occupied 49% market share in US. However,

new forms of payments encroached on the demand of check-printing industry. The demand for

printing check falls at 1% to 3% annually. The core business of Deluxe faces a big challenge.

In the late summer, Singh, the retained by Deluxe’s board of directors was designated to submit a

plan for the new round of debt issuing. It’s certain that someday in the future the company may

struggle to survive. In order to deal with bad situation in the future, Deluxe must maintain

financial flexibility and lower its cost of capital by changing into appropriate capital structure.

There are three alternatives in this case. They are issuing bond at AA, A and BBB rating. And in

each situation, we get the lowest WACC. In the implementation, we decide to issue bonds at

rating BBB.

Problem Statement

Deluxe Corporation will face a big challenge for its core business which means that the company

would struggle to survive in the future. There is a new round of issuing debt at hand which may

help Deluxe to relieve some pressure for the future. This new debt could help increase financial

flexibility and change capital structure which produces lowest cost of capital. So the key issue

here is : what’s the best debt policy for Deluxe corporation?

Alternative

In 2001, Deluxe Corporation has long-term debt of 10.1 million. According to calculation, the

long-term debt/capital is 3.65% which is below the high limit of rating AA. Besides, Singh

intends to preserve the investment-grade rating which is BBB. Hence, if Deluxe wants to issue

bond to change its capital structure and lower cost of capital. The rating range for Deluxe is from

AA to BBB.

Issue bond at rating AA:

According to the rating category, if Deluxe tends to maintain at AA rating. The Long-term

debt/capital (%) should between -1.1% and 21.1%. So we calculate maximum and minimum

bond issued as following:

AA
Max debt 61.33
Min debt (13.01)

Singh wants to lower the cost of capital as well. Because the cost of debt is lower than the cost of

equity. The more debt, the lower the cost of capital. Therefore we get lowest WACC of 7.05%.

AA Tax rate 38%

Cost of debt(pretax) 5.50%
Cost of equity 10.35%
Debt 0.48
Equity 0.52
WACC 7.05%

Issue bond at rating A:

If Deluxe tends to maintain at A rating. The Long-term debt/capital (%) should between 21.1%

and 33.8%. So we calculate maximum and minimum bond issued as following:

A
Max debt 126.274
Min debt 61.33

Also, we can get lowest WACC which is 6.08%.

A Tax rate 38%

Cost of debt(pretax) 5.70%
Cost of equity 10.50%
Debt 0.63
Equity 0.37
WACC 6.08%

Issue bond at rating BBB:

If Deluxe issues bond at BBB rating, the maximum Long-term debt/capital (%) is 40.3%. Then

we calculate the amounts of bond as following:

BBB
Max debt 170.204
Min debt 126.274

In this case, we can get lowest WACC which should be 5.94%.

BBB Tax rate 38%

Cost of debt(pretax) 6.30%
Cost of equity 10.60%
Debt 0.70
Equity 0.30
WACC 5.94%
Conclusion

After weighing those alternatives, we believe that issuing bonds at rating BBB would be the best

choice for the firm’s financing. In this way, the firm could fully exploit its leverage and it would

really alleviate the stress of the firm undertaking the program that repurchases the shares.

At rating BBB, the firm could collect 170 million dollars at maximum and 126 at minimum, and

the WACC would decrease to 5.94%. If issuing at rating AA, the firm could collect 61 million

dollars at maximum, and the WACC would be 7.05%. If issuing at rating A, the firm could

collect 126 million dollars at maximum and 61 million dollars at minimum, the WACC would be

6.08%. Both alternatives A and AA are not as favorable as BBB, especially at the time which the

firm is aggressively determined to repurchase stocks and create value for shareholders, and as the

market for check is mature, even though the firm is at leading place, there is not too much

margin for revenue growth. So a lower cost of capital would go a long way for the firm’s

survival. Of course, a better rating would help to create a favorable image for the firm’s brand,

but BBB is still an investment grade bond, so it would not undermine the brand too much.

In a nutshell, issuing bond at rating BBB would balance the firm’s different goals and it best

suits the firm’s needs under current circumstances.

Implementation

According to the analysis for credit rating of Deluxe Corporation, the best method of financing is

to issue AAA bonds. Deluxe Corporation needs to mix the classes of capital. They should

consider the risk of issuing bonds and equity, how heavily the firm relies on different classes of

capital.
However, as a mature business, Deluxe Corporation aims not to minimize risk, but to maximize

value which includes shareholder wealth and the value of the entire firm. The dividends per share

tell shareholders the profitability of the firm. Historically, Deluxe Corporation tended to

distribute dividends which made the shareholders confident in the operation of the firm. To

afford the dividends, enough earnings are a must. Deluxe Corporation can issue more short term

debt like commercial paper whose interest is only 1.85%.

While lowering the WACC, the company should make effective financial decisions to meet the

internal goals. The core issues for Deluxe Corporation are the decline of the sales and earnings

growth and the discontinued financial flexibility. To improve the sales and earnings growth,

Deluxe Corporation needs to understand if the financial policy creates a competitive advantage

compared with competitors. For example, repurchasing the stock increases the stock price and

earnings per share. This conveys a message that the company has been over the difficult times.

As a result, more investors would be optimistic to the company. They may invest capital in the

company. More cash would release the shortage of funds so as to increase the financial

flexibility.