By: Michael Malone Statement of the Problem Rajat Singh, a managing director at Hudson Bancorp, needs to find a way to rejuvenate the paper check corporation. One main part that needs to be calculated is the appropriate mixture of debt and equity for the firm. The company needs to determine the correct mixture so that they can both minimize the cost of capital and increase the shareholders value. I will analyze the current and future situation of the company, trying to find the correct credit rating to use that will increase income.
With the new credit rating, I will be able to recommend a certain amount of debt for the company to take on and be profitable. Facts and Assumptions When trying to accurately calculate the cost of capital, the one main method stands out the most. I had to calculate the WACC of the firm for the various credit ratings. In order to accurately calculate this, I had to incorporate the repurchase of shares and add the newfound debt to the total debt from 2001.
The project debt used by the corporation didn’t factor in the repurchase of shares and therefore it was calculated wrong.
To help me solve the equation for the best WACC, I had to make some basic assumptions about the case. For starters, as shown in case, I decided to use a 37% tax rate like the analysts for Bancorp did because I felt that it would be comparable to the numbers that they calculated in the projection.
Next, I decided to use the 5-year note yield because analysts provided information to show that the market would mature after 5 years and paper checks would be nonexistent. Furthermore, I had to use the CAPM equation to figure out what my numbers would be for the WACC equation.
To show this, I used the equation: CAPM = Rf + (Rm-Rf) ? Through the use of the case, I was able to assume a risk free rate of 3. 45% while I used 11. 03% for the market risk premium and 0. 85 and the beta. This led us to the calculation of the cost of equity, which we could then use to find the debt. Once the debt was found, I needed to find the bond rating perfect or it and I believe that I found a winner. Analysis Using CAPM to provide the calculation for the equity, this presents both positive and negative effects.
Advantages 1. Calculates the amount of compensation the investor demands for taking additional risk 2. Compares the returns of the asset to the market over a period of time (Beta) Disadvantages 1. Based on historical data onto the future (Beta is an estimate) 2. Simplifies assumptions about the market and how investors will actually behave. Taking the CAPM equation, we were able to figure out eh cost of equity and in its credit range CAPM = Rf + (Rm-Rf) ? =3. 45%+(11. 03%3. 45%)*0. 85 CAPM= 9. 89%
With this, we can then find each of the costs for equity by averaging them within each of the bond rating categories. This showed a very flat performance in cost of equity. I we compare that to the market beta, our answer for CAPM would change from the 9. 89% to the 11. 03%. According to exhibit 8 in the case, a cost of equity of 11. 03% is between a BBB and BB bond rating. Therefore, if they were to repurchase stock from investors, there share prices would in theory go up because they are investing more and more money into the company.
With the three debt instruments in the case, hundreds of millions of dollars would become readily available to the company and be at their disposal. Each of the financing opportunities provides their own money in different forms. Great companies need these different financing ideas to succeed. Recommendation Based on the analysis performed, Deluxe should definitely consider the different financing opportunities that are presented to them. By epurchasing stocks with debt, the stock price will increase from $41. 58 to $47. 04. This will bring some much needed value to both the company and its investors. In my opinion, the company shows a good potential to continue to grow during the recession through he addition of new financing opportunities and buyback of some stock. To get this to happen, it would require the company to use 1,140. 10 million dollars of debt which would equate to a mixture of 64. 85% debt and 35. 15% equity.