Deluxe Corporation Teaching Note
4197 WordsDec 8th, 201417 Pages
Synopsis and Objectives
Suggestions for complementary cases in capital structure choice and financial flexibility: “The Wm. Wrigley, Jr. Company: Capital Structure, Valuation, and Cost of Capital,” (case 30); “Rosario Acero S.A.,” (case 32); “Gainesboro Machine Tools Corporation,” (case 25) 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…show more content…
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. 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. Is Deluxe’s current debt level appropriate? Why or why not?
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
Supporting Spreadsheet Files
To assist student preparation, the instructor should consider making available to the students the Microsoft Excel spreadsheet file, Case_31.xls, which contains a number of the exhibits and a working forecast model. The spreadsheet file TN_31.xls supports instructor preparation of the
Gainesboro Corporation was a company who designed and manufactured a number of machinery parts, including metal presses, dies, and molds. The company was found in 1923 in Concord, New Hampshire, by two mechanical engineers, James Gaines and David Scarboro. The two men had gone to school together and were disenchanted with their prospects as mechanics at a farm equipment manufacturer. In the 1940’s Gainesboro produced armored-vehicle and tank parts and miscellaneous equipment for the war effort. And then in the early 1980’s, they focused on manufacturing machinery parts, war equipment, and now entered new field of computer aided design and computer aided manufacturing (CAD/CAM).
Ashley Swenson, chief financial officer (CFO) in mid-September 2005 needed to submit recommendation to Gainesboro’s board of directors regarding the company’s dividend policy. The Gainesboro’s stock also fallen 18%to $22.15 due to post impact of the Hurricane Katrina. Now, Ashley Swenson’s dividend decision problem was compounded by the dilemma of whether to use company funds to pay shareholder dividends or to buy back stock.
Stock Price per share = $22.15
Net income in year 2005 = $18,018,000
Number of shares = 18,600,000 shares (assumed number in year 2004 is
still the same with year 2005)
Earnings per share = $0.98
Price to earnings ratio ( P/E Ratio)=(Price per share)/EPS
Number of retired shares=(Net income)/(Price per share)
Number of retired shares=18,018,000/22,15=813,453.72≈813,454
Therefore, number of shares outstanding
Then we can calculate the new EPS after repurchase stock,
Earnings per Share (EPS) =(Net income)/(Number of shares)
Thus, the new market price is =EPS x PE Ratio=1.013 x 22.6=$22.89 It can be seen that by buying back the stock, the market price can increase for 3.34%.
>Pay shareholders dividend
a. Zero dividend payout Policy
This policy required the company will not pay dividend from 2005 to 2011.In the year 2005, The company expenditure was about $63.3 million dollars but the amount of the total sources was only $40 million, so in order to balanced the company financial condition, the company borrowed $22.7 million. The same thing was also happened in 2006, the company borrowed $7.3 million (total expenditure $72.8 million –total source $65.5 million). From 2007 to 2011, the company excess cash are positive ($4.2, $11.5, $29.4, $27.2, $77.6) million, these situation happened because the total expenditure remained lower than the company total source, so the company did not have to borrowing needs.
So, by sum all of the excess cash and the borrowed money data from 2005 to 2011, we can calculate that the company total excess cash is $120 million. This kind of policy has the best impact on company’s financial condition because of the absence of dividend that will reduce the company’s retained earnings. Retained earning posses a greater role to make sure the company runs smoothly in the future by using minimum portion of debt required on a project, reflected in the industrial zero-dividend payout ratio.
b. 40% dividend Payout
From data in exhibit 8, 40% dividend payout means that the company will pay dividend 40% from net income from year 2005 to 2011. This results and the total excess cash for borrowing needs from 2005 to 2011 is ($95.1) million.
The company will do borrowing from year 2005 to 2010. Amount of money borrowed respectively, ($29.9), ($23.3), ($18.8), (17.6), ($7.2), and ($12.0). All of the value comes from deduction of the total expenditures to the total sources.
Year 2011 the company will get $13.6 million excess cash ($212.5 million – $134.9 million). $134.9 million is from the total expenditures (capital expense + change in working capital). And $212.5 million comes from the total sources (net income + depreciation).
By sum up all of values (excess cash and borrowed money) from year 2005 to 2011 we get the total cash flow of ($95.1) million. By raise dividend payout from 31.4% in 2004, 140,784(Net income)/0.25(dividend per share) to 40% company need excess cash 95.1 million; only in 2011 the company gain profit. The following is the calculation table:
c. Residual-payout Dividend
The following is the calculation for the residual-dividend payout:
By applying residual payout policy, at the total of excess cash from year 2005 to year 2011, Gainesboro still experiences negative cash. It means they will still have to borrow extra cash to pay the dividend.
Conclusion and Recommendation
Based on the market price value, EPS, and P/E Ratio calculation, the company’s stock will have higher market price if they buy back the stock. Therefore, it’s recommended to buy back stock instead of paying dividend. It is also supported by the comparison between zero payout dividend, 40% payout ratio, and residual-payout. The best ending cash the company has is when they do zero payout ratio, which means they don’t give dividend at certain years. Since, to pay the dividend they will have borrowing need forcing them to increase the debt level. Meanwhile, they current debt level is already higher than the maximum level management expect which is 40%. The year 2005 debt to equity ratio is 140%. Also, without paying dividend, the company still can attract investors. It is shown from the P/E ratio that is in average if compared to other similar companies.