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 9.95%. 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
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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
First, the projected cash flows range from $21.2 million in 2007 to $29.5 million in 2011 as shown in the data exhibit ‘DCF model.’ To generate these numbers Liedtke’s base case performance projections are used for the projected 2007 – 2011 net revenue numbers and the estimated depreciation and then his projections for Balance sheet accounts were used to determine the current net working capital and capital expenditure as in the exhibit ‘Financial statements.’ These projections were based by Liedtke under the following assumptions, women’s casual footwear would be wound down within one year and the historical corporate overhead-revenue ratio would conform to historical averages. These annual cash flows give us a PV (Cash flows) of $96.15 million over the next 5 years.
3. Compute the unlevered free cash flow and the interest tax shields from 2008 to 2012 based on estimates provided in Exhibit 1 and Exhibit 6. (3 points)
The questions that follow and the article Comparing the Accuracy and Explainability of Dividend, Free Cash Flow, and Abnormal Earnings Equity Value Estimates will inform your completion of Milestone Three. An understanding of the models in this assignment will assist you in hypothesizing the incremental impact of a new investment project for the company. The understanding of these models will contribute to your ability to look toward the future when considering the direction of an organization. This activity is worth a total of 75 points. See the distribution of points listed before each question.
Our approach to valuing the processing plant can easily be decomposed into three distinct steps first, find the value of the foreseeable free cash flows. Next, calculate the terminal value of the project. Finally, take the present value of those flows. The next few paragraphs walk through each of these steps in order of progression.
This represents a 7% increase in stock price. Further, the additional leverage and return of excess cash to shareholders will significantly increase ROE. If the market determines that an 80% debt capital structure is feasible for BBBY, then we will expect further capital gains as investors applaud shareholder friendly policies and re-examine EPS estimates. However, if top line growth and same store sales growth continue to trend downward, investors may become skeptical of BBBY management’s ability to continue generating over 30% EPS growth, and thus question the ability of the company to service its debt in the future.
An analysis of a repurchase of stock for $400 million cash, and recapitalization to 80% debt-to-total capital by borrowing $1.27 million reveals that BBBYs return on equity will be 113%, return on assets 61% and an after tax cost of debt of 28%. ROE is > ROA and ROA > after tax cost of debt. With the 80% debt-to-total capital structure ROE exceeds the other two capital structure scenarios of no debt and 40% debt-to-total capital. While all of this looks great there are other considerations. The household and personal products industries debt to total asset ratio is 34.69% while BBBY debt to total asset ratio is at 44% ($1,270,000/$2,865,023). Increasing to this capital structure would also reduce shareholders earnings per share.
Next, the terminal value at year ten was calculated. The following formula was used to do so: terminal value at year 10 = (FCF at year 11)/(WACC - g). This time we used the long-term growth rate of 7up, which was given by the case as 1% less than the industry rate. This resulted in a terminal value of $848M with its present value calculation being $231M.
After considering the operational improvements forecasted, we project Robertson’s free cash flows and compute the terminal value using the Gordon Growth Method; the implied share price is analyzed further in accordance to growth rate and discount rate.
This case raises many interesting questions concerning the record setting issuance of corporate debt by WorldCom, Inc. (“WorldCom”). Both the surprisingly voluminous structure of the proposed issuance and the foreboding macro-economic climate in which it was slated spark concerns over the risk and cost of the move. One of the first questions that must be addressed is whether WorldCom’s timing was appropriate. Next, the company’s choice of structure for the bond issuance must be analyzed. Finally, the cost of issuing each tranche of debt must be estimated in order to determine how much WorldCom is actually giving up to achieve the $6 billion in funds.
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 purpose is to recommend an appropriate financial policy for the firm and, in support of that recommendation, to show the impact on the firm’s cost of capital, financial flexibility (i.e., unused debt capacity), bond rating, and other considerations.
We valued the company using four different methods; Net Present Value, Internal Rate of Return, Modified Internal Rate of Return and Profitability Index. We began with the Net Present Value, or NPV, calculation. NPV values an investment’s profitability based on the projected future cash inflows and outflows of the investment, discounted back to present value using the WACC. The calculations for NPV are presented in Appendix 2. We started by separating cash inflows and outflows by each year. We used Bob Prescott’s estimates for the revenue per year and related operating costs of cost of goods sold as
The first part of the company evaluation was focused on the historical performance of the company for the last 5 years and projection of its free cash flow in the future. As presented in Appendix 1, in those years the Allianz Group faced fluctuations in its total income but managed to keep its business profitable, with total expenses averaging around 93% of its Total Income. In terms of growth, the company is expected to grow at a slower pace, 2,4% in 2012 due to the variety of cataclysms faced throughout the year. In coming years however, the strong Real GDP growth of 5,5% in the emerging markets (representing close to 50% of company’s clients), a steady growth of 3,22% is to be expected.
6. The project requires an initial investment in plant and equipment of $6 million. This investment will be depreciated straight-line over five years to a value of zero, but, when the project comes to an end in five years, the equipment can in fact be sold for $500,000. The firm believes that working capital at
What is the relevance of the terminal year cash flow? Which factors must be considered when estimating the terminal year cash flow?
*We calculated the cash flows of the firm and discounted them by our WACC, which was roughly 16%. We used a terminal growth rate of 6% (Exhibit 1)