Summary of the case

1.Market Premium-you have to think critically about Hudsons methodology and

resulting view that equity investors are indifferent to the increases in financial risk
across the investment grade debt categories. I believe their estimate of 10.25% for
the AAA group is arrives at in the following manner. Assuming a risk-free rate of
5.3% (30-year Treasury bond) and a 5.4% market risk premium, the security market
line can be solved for BL, the levered equity beta:
0.1025=0.0530+ BL (0.054).
So take 5.4% as market or risk premium.
The implied estimate of BL is 0.92. this suggests that the average beta of the firms with
an AAA rating was estimated to be 0.92 by Hudson. The levered beta depends on
the underlying business risk of the firm and the use of leverage. Indirectly, Hudsons
method assumes that firms rated AAA have similar business risks and are financed
in a similar manner. It is likely that AAA rates firms have low debt usage, although
this assumption may not fir as well across other rating categories. Moreover, the
business risk of AAA firms need not necessarily be the same. One interesting
implication of this analysis is that it seems to suggest that all firms, regardless of
the business, would find the lowest capital costs at a BBB rating.
An alternative approach to Hudsons is to unlever Deluxes levered beta to isolate
Deluxes business risk (i.e., find unlevered of equity, B U ) and then relever BU to the
corresponding levels of debt for each category. the resulting levered beta may be
used as the basis for the capital asste pricing model estimates of the cost of equity.
This analysis is developed in the lower panel of Excel Sheet. Unlevereing Deluxes
beta of 0.85 (provided in the excel sheet) yields an estimate of 0.82. it is important
to recognize that this estimate is higher than the estimate implied in Hudsons
analysis, and that it explains some of the difference in the results of the two
approaches.
Flexibility- the excel sheet suggests that if BBB is to be Singhs target minimum
debt rating, then the firm will need to adjust its debt $161 million toward the $1
billion level.
Risk- exhibit 10 indicates that the firms coverage expense has improved
significantly since retiring it long-term debt in Feb 2001. If Deluxes earnings arte
sustainable, then a high level of debt is acceptable, but the likelihood of that
outcome can be questionable.
Income (or Value)reducing leverage with an equity issue will dilute the share price
and sacrifice the befits of debt tax shields.
Control- the firms commitment to share repurchases indicates a desire to maintain
control. Funding will be required to support that strategy.
Timing- Interest rates are rising, as suggested by the comparative yield curves in
Exhibit 9. Depending on ones long-term interest-rate outlook, one might want to
sell more debt now (before rates rise further); alternatively, one might want to sell
equity now (when it is somewhat overprices) and wait to sell debt later when
interest rates decline.

Debt Limit- refer excel sheet.