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 34); “Rosario Acero S.A.,” (UVA-F-1211); “Gainesboro Machine Tools Corporation,” (Case 26) 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 student must recommend an appropriate financial policy for the firm and, in support of that recommendation, must show the impact on the firm’s cost of capital, financial flexibility (i.e., unused debt capacity), bond rating, and other considerations.
This case may be used to pursue a number of teaching objectives:
• 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 affords 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 trade-off 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. Suggested Questions for Advance Assignment
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. 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_35.xls, which contains a number of the exhibits and a working forecast model. The spreadsheet file TN_35.xls supports instructor preparation of the case, and should not be distributed to students.
Recommended Collateral Readings
This case is effective if used without other supporting readings. Depending on the instructor’s objectives, however, and the time available for student preparation, the following readings would deepen the students’ engagement in this case.
Barclay, Michael J., and Clifford W. Smith Jr. “On Financial Architecture: Leverage, Maturity, and Priority.” Journal of Applied Corporate Finance (Winter...