Risk Associated With Business Case Study Sample
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The paper discusses the possible risks to the Deluxe Corporation business of printing checks, and how Mr. Rajat Singh can help them in their financial rejuvenation. Deluxe Corporation’s CEO is expecting tough times ahead for the company because of proliferation of financial technology and e-transaction of funds. In addition, the company has retired all its debt and has also initiated share repurchase program. Hence, a prudent advice will be expected from Mr. Singh to revive the company, while maintaining its current investment rating in the industry.
Question No. 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?
Deluxe Corporation is an American company that deals in the manufacturing of business paper checks. With sufficient cash position, the company had discharged all of its long-tern debts and has also not issued any corporate bond to raise further debt since past 10 years. Although, the company is at mature life-cycle stage of business, the CEO of the company, Lawrence J. Mosner fears that the biggest upcoming risk for the company is the possible decline in demand of business paper checks as the financial system will soon rule of out use of paper checks with aggressive proliferation of financial technology in the form of Automated Teller Machines (ATM), e-transfers, credit cards, et cetera. Thus, with customers getting inclined to virtual pathway for financial transactions, there will be a little scope for the company to expand and it is possible that soon it might experience saturation level of demand.
Thus, after considering the view point of CEO of the company, we can assume that the company will face two kinds of risk:
Survival Risk: Since the CEO of the company has notified that he is expecting a significant downfall in the demand for business checks is near visible, and the proliferation of electronic financial transactions will be responsible for the downfall of the company’s business. Furthermore, with consumers inclining towards e-funds, the company may also not able to cash the growth opportunities, and might soon face survival risk.
In addition to the above concerns, Deluxe corporation has also lost its divergence benefit by spinning-off two companies which were closely related to the business of electronic payments, and could have provided better opportunities at the time of saturated demand for business checks.
Downgrade risk: Referring to the financial forecasts of the company we found that future forecasts are really strong. The cash flow of the company is projected to surge from $212 million in 2012 to $229.7 million in 2006, while cash position is expected to rise to $625 million in 2006, while debt level stays constant at $161.5 million. Revenue figures are forecasted at the rate of around 26.7%. Thus, forecasted figures are really encouraging; however, with possible slow-down of the company, the company will face downgrade risk for all the above financials, and any issue to raise the capital will also be low-rated by the credit agencies, forcing the company to raise capital at high interest rate.
Possible financing requirements in the future:
Buyback spending: The company has initiated the share-repurchase program, and now with the paradox situation where CEO is expecting that company may soon face tough times, it has to arrange funds to complete its share-repurchase program else this will send negative signal amongst the investors.
Working capital needs: Additional funds will be required to assist with the working capital needs of the company.
Payment of cash dividends: Company will need funds to continue dividend payment as any suspension of dividend will again send a negative signal to the investors.
Maintaining overall financial flexibility: Deluxe Corporation will be requiring funds to maintain the financial flexibility in the company; if the demand for the company’s product starts falling and expectations of CEO turns true.
Question No. 2: What are the main objectives of the financial policy that Rajat Singh must recommend to the Deluxe Corporation’s board of directors?
As disclosed in the case study, Deluxe Corporation has already completed the spin-off of two companies, efunds and IDLX, and finally placed itself as business check printing company. However, with company’s CEO forecasting significant decline in the demand because of expansion of e-transactions, the financial position of the company will be affected significantly as with spin-off of the above two companies that were related to e-payments business, the company is not left with any option of diversification and restructuring. Furthermore, the company is also done with its share repurchase program. Hence, the sole objective of financial policy that Rajat Singh must recommend to the Deluxe Corporation to the board of directors will maintaining the similar investment rating, minimize the cost of capital, and to ensure that the company remains potentially and financially attractive to the investors. However, in order to achieve all these objectives, Mr.Singh should clarify the following aspects related to funding to the company’s board of directors:
‘’ There is a general concept that bond with higher credit rating will have the lowest cost of debt. However, this is not a good notion as credit ratings gives information about default risk and does not guarantee lowest cost of capital. Thus, in order to minimize the cost of capital, all Deluxe Corporation needs to is to analyze its WACC, and selecting the rating category for debt issue with least WACC. As we know, WACC also provides minimum benchmark rate that company must earn to at least break-even. If company earns returns below WACC, this will result in losses, vice-versa. However, ironically, selecting funds at WACC alone cannot give the optimal value for the shareholders and only provides cost range to the company. Rather, WACC and market value of the company goes together. Generally, as WACC starts to decline, market value increases, and there will be a point which is an optimal level where the difference between WACC and market value will be maximum, and eventually company will be maximizing its shareholder value.’’
Hence, Mr. Singh must clearly recommend that although Deluxe Corporation should maintain a high credit rating, but it will only be possible if it concentrates on maximizing its shareholder value.
Question No. 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?
As extensively discussed in the case study, the company has already discharged its debt, and with alarming future situation where it is doubting the survival of check printing business, the company will soon need additional debt to fund new projects. Below is the summary of debt that the company can raise at each rating level where we assumed the worst case and best case scenario EBIT:
Debt issue under each of the above investment rating will affect the following capitalization ratios:
i)Debt to Total Debt
ii)Total Debt to Equity
The effect on capitalization ratios from borrowing under each category with an assumption of worst case EBIT and base case EBIT is as follows:
i) Effect on capitalization ratios under assumption of worst case EBIT of $200 Million:
Extending our discussion of how Deluxe Corporation can maintain high investment rating through lowering cost of capital, and subsequently enhancing the shareholder value, we checked how WACC changes under the different categories of investment ratings under the best case and worst case EBIT scenario. As we can witness from the worst case EBIT scenario of $200 million, the WACC is lowest for BBB rating issue where the company will be able to raise capital at 5.15%, while issue under other investment ratings will cost higher to the company. Hence, in order to achieve the objective of maintaining similar investment grade, Deluxe Corporation should raise debt at BBB rating.
ii) Effect on capitalization ratios under assumption of worst case EBIT of $344.8 Million:
We even employed the debt scenario to the best case EBIT scenario of $344.8 million, and found the similar results as here also, lowest WACC is achieved at BBB rating.
Hence, in continuation of what we discussed in question 2, it is very much evident that in either assumption relating to EBIT, Deluxe Corporation will benefit the most from debt issue in BBB rating as this is where they will be able to raise capital at the lowest cost possible
Brown, K. (2011). Cost of Capital. In C. Institute, Corporate Finance (pp. 34-41). Boston: Custom.
Bruner, E. a. (n.d.). Case Studies in Finance:managing for corporation value creation,.
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