Deluxe Corporation Capital Structure Analysis and Strategy

Introduction and Capital Structure Overview

Deluxe Corporation is a leader in the check printing industry. However, the company has recently encountered financial structure problems associated with obtaining the most optimal capital structure. The objective of this analysis is to assess the recommended capital structure alternative and its impact on Deluxe's current financing arrangements.

The primary problem with the current capital structure is the company's reliance on equity-based financing. As a result, Deluxe will not generate the free cash flow necessary to repurchase company stock at the accelerated rate projected by Singh. The cash on hand that Deluxe does generate will instead need to go toward maintaining operating capital to finance daily operations.

Secondly, the firm does not maintain or manage flexibility in financing effectively. The optimal choice is to issue debt, since the company's 37% tax shield makes debt financing very attractive — effectively reducing its cost by approximately one-third. However, this advantage was not managed properly, as too much equity financing was used. This increased shares outstanding (and the free float) and lowered the stock price. The stock repurchase program proposed by Singh would cause the stock price to appreciate due to the reduction in shares outstanding.

Current Problems with Deluxe's Capital Structure

Additionally, the company's failure to capitalize on the benefits of debt financing created a higher overall cost of financing. Meanwhile, the emergence of new technology — such as electronic payments — has forced Deluxe to streamline its business and constrained the firm to focus only on its core activities. This unfavorable external environment has further reinforced the specific requirement for debt financing.

The decision to obtain financing by issuing AAA-rated bonds to fund future operations will yield a positive impact on the capital structure, as the tax benefits accrued through the tax shield and the interest coverage ratio lower the cost of debt financing. By increasing AAA debt financing and reducing investment in equity financing, the wealth of Deluxe will increase as a function of retained earnings and shareholder value, thereby producing a positive future impact. The financial return will result in higher earnings per share (EPS) and a greater market share for Deluxe.

The ability to use the weighted average cost of capital (WACC) to manage the debt-equity balance will enable Deluxe to keep its financing structure efficient. Financing decisions based on WACC are viable when the firm invests in products with an internal rate of return (IRR) greater than the cost of borrowing at the WACC.

The long-term plan for Deluxe is to increase its market share by growing its customer base, then retire outstanding equity shares while maintaining an optimal level of debt outstanding. This would render a lower debt/equity ratio and increase the target wealth of each investor.

In order to address the aforementioned problems effectively, we recommend Deluxe Corporation adopt the following measures:

Recommendations to the Board

1. Acquire more debt to attain a lower cost of capital. Simultaneously, diversify the current business to maintain market share and secure future cash flow.

2. Deluxe should first reach a debt level of $810 million, because this will immediately reduce the current WACC and thereby increase the value of the firm.

3. Deluxe should prevent its debt from losing its current credit rating, which would otherwise result in paying a higher rate of interest on its outstanding debt.

4. Deluxe should issue commercial paper to pay for its short-term obligations and invest its revenue stream at a rate higher than the cost of financing those short-term obligations using commercial paper.

To accomplish these goals, Deluxe must optimize its equity trading price, preserve its debt capacity (i.e., its ability to issue more debt while retaining its AAA debt rating), and optimize the cost of capital while preserving a strong debt rating by meeting debt payments through the cost of capital. Finally, Deluxe must align all operating decisions with its financing strategy.

The recommendation to Deluxe and to Singh is to repurchase only a portion of the outstanding stock that Singh originally recommended — approximately $200 million, well within the financial capacity of Deluxe — over the next three months, in order to increase the share price. After the three-month period, Deluxe should issue more debt and liquidate shares within the rules and limitations of the SEC to cover the cost of servicing the debt by paying the cost of capital. This will maximize the debt/equity ratio and provide a structured approach to financing the debt while keeping the cost of capital low.

The operations of the business must reflect Deluxe's financial strategy. Currently, Deluxe holds the largest market share in its sector and is positioned to benefit most from the transition to electronic checks. The debt taken on by the firm should be used to acquire a small electronic checking company that specializes in software development for integrating checking clients into stored databases for payroll and checking services. This would provide better and more integrated service to existing clients and enable additional sales by attracting new clients seeking that level of service.