Case 35: Stock Repurchase Program Recommendation

Memo To:Rajat Singh, managing director at Hudson Bancorp From: Date:08/01/2002 Re:Stock Repurchase Program Recommendation The purpose of this memo is to examine whether Deluxe Corporation should increase borrowings to buyback stocks. After considerable analysis of the company’s financial position, we recommend that Deluxe Corp. to borrow up to $1. 023 billion to buy back 34,175 shares. In order to achieve this, Deluxe will need to lower its bond rating from A rating to BBB , which results in a decrease in WACC from 11. 47% to 9. 5%. By doing this, Deluxe ’s WACC is minimized, yet the bond rating is still at investment –grade rating; plus, the firm will have a financial flexibility of $872 million, and an increase in its equity value per share by $35. 34. This memo explains in detail the calculation of the current WACC, the current intrinsic equity value, the unused debt capacity at different ratings, and the recommended WACC as well as the estimated increase in equity value with respect to the new WACC at the recommended debt borrowing level.

Current WACC Based on our calculation, the current WACC is 11. 47% as of August 01, 2002. In this calculation, for the borrowing rate, we use 5. 70% regarding Deluxe’s bond rate A from Exhibit 8. The marginal tax rate is is projected to be 38%. We use 5. 41% for the risk free rate of return with respect to the 20 years U. S Treasury bond. The equity risk premium and beta are given at 6% and . 85, respectively.

Since the beginning of 2002, Deluxe had retired all of its long term debt, we calculate the total debt by adding the short-term debt and the long-term debt due within one year to arrive at $151 million; for the total equity, we multiply the number of shares outstanding which is given in the company’s 2001 Financial Summary, by the market adjusted close price per share which we look up in yahoo finance to get to $1,568 million. For the small stock risk premium, we use 1. 73% as Deluxe’s total equity is between $1. 05 billion and $1. 6 billion. Current intrinsic equity value

Deluxe’s intrinsic equity value as of August 1, 2002 using a discounted cash flow analysis and the current WACC of 11. 47% has a premium of $2. 38 over the current market value. We estimate the terminal value growth rate to be at -2%; we make this assumption by taking the average of the industry’s annual decline growth rate between 1% and 3%. The free cash flows for 2002-2006 are taken from the company’s Financial Forecast; and, to calculate the terminal year’s free cash flows, we grow it by -2% and divide it by the difference between the WACC and the long term growth rate.

Since August 1st is our evaluation date, there is still 5 months left for 2002, the cash flow to be received for 2002 is calculated by taking the total cash flow times 5/12, and for the remaining years, the cash flow to be received is equal to the total cash flows. And, finally, for the midyear factor ,we also take same caution that t are 5 months left to receive cash flows, and payments are made semiannually . Thus, our mid-year factor for 2002 is 5 over 24, and (5+6) over 12 for 2003, and for the remaining years we add 1 to the prior year’s midyear factor.

Flexibility by rating Our analysis of the flexibility in allowed debt under each bond rating provided us the maximum allowable unused debt for each rating. We calculated this figure by considering both the interest coverage ratio as well as the leverage ratio, and then using the smaller of the two figures. We calculated the maximum allowable debt using the leverage ratio by multiplying the five-year EBITDA average times the required leverage ratio under each credit rating. The lower the credit rating the larger the allowable debt becomes.

By choosing the lower of the two calculations, the maximum allowable debt under credit rating AAA is 278. 9 million and ranges up to 2,456. 6 million for bond rating B. In order to maintain an investment grade rating, Deluxe’s maximum allowable debt would be 1,023. 5 million. Recommended WACC In calculating the WACC for each bond rating, we altered several components for each. First, the borrowing rate increases as the bond rating decreases. These figures were provided in Exhibit 8. Second, we recalculated beta taking into account the changes in the debt/equity capitalization structure using.

The re-levered beta was calculated using the levered and unlevered information. Third, as ratings declined their debt/equity ratio increased and altered their weighted cost of debt. Fourth, their equity/debt ratio decreased as their bond rating declined. Our final calculations of the WACC for each bond rating went from 11. 47% at AAA down to 9. 95% at BBB and back up to 11. 02% at a B rating. We recommend using the debt level allowed under the BBB rating since it maintains our status as investment grade bonds and also provides the lowest possible WACC. Estimate increase in equity value

To determine the number of shares to be repurchased in the upcoming repurchase program, we used the maximum allowable debt under the BBB bond rating and subtracted our current debt to determine the total funds to be used to repurchase shares. In order to determine the number of shares that could be repurchased, we divided the total allowable debt by the current market per share price. This resulted in a recommended repurchase of 34,175 shares. Next, we conducted a free cash flow analysis to determine the intrinsic enterprise value of Deluxe Corporation.

This analysis is similar to the one conducted for the Current intrinsic equity value. However, we lowered the WACC to reflect our recommended credit rating. In estimating the total increase in shareholder value from this repurchase program, we took enterprise value minus the maximum allowable debt at the BBB rating. This gave us the equity value of Deluxe Corporation. Then, we divided the equity value by the current outstanding shares net of the repurchase program. This gave us equity per share value of $63. 24. In comparing this to the old equity per share value, we found an increase of 127%.

This is a highly favorable move for the shareholders of Deluxe Corporation. Concluding Recommendation We believe Deluxe Corporation should borrow funds in the amount of $872 million for the stock repurchase program. By borrowing these funds, Deluxe Corporation will be able to increase their equity value per share by 127% while still maintaining investment grade status. Deluxe is aiming for a flexible capitalization structure, and by borrowing more debt we believe they can achieve this due to the high cost of equity. If you have any question or concern, please feel free to contact us via emails: