Q.No.

4: Using Hudson Bancorp’s estimates of the costs of debt and equity in case Exhibit 8,
which rating category has the lowest overall cost of funds? Do you agree with Hudson
Bancorp’s view that equity investors are indifferent to the increases in financial risk across
the investment-grade debt categories?

There is a general concept that higher rating category will have the lowest cost of debt. But
rating categories only give the information about the default risk and loss in case of company
default. It does not guarantee the lowest cost of capital. For the lowest cost of capital we must
need to analyse the WACC and we should select the category providing less WACC but the
category must be at-least BBB.

WACC is the minimum rate of return that a company must earn in order to stay in the break-
even position. Return below the WACC will lead the company toward deficit, so every
organization wants higher return than its WACC. Companies generate its funds from various
sources like: securities, debt, convertibles etc. and all these sources have certain weight.
Therefore, WACC considers all the sources and the cost associated with them along with the
weights of the sources.

WACC alone cannot give the optimal value for the shareholders; it only provides the
minimum cost range. WACC and market value of the company move simultaneously and
these two are the major determinant of rating category. Generally, as the market value
increases, WACC starts to decline. In the process there will be one optimal level where the
difference between WACC and market value will be maximum(Refer to the graph below);
similarly level of debt-to-equity will be maximizing the shareholders’ value?? Yo line pad ta
ek choti

Therefore I opine that the company should not focus more on credit rating, rather it should
concentrate on maximizing the shareholders value. By maintaining minimum WACC,
company can get its range for optimal credit rating. This can be shown by figure below:
 WACC MAXIMUM

Optimal Level

MINIMUM

Credit Rating

Shareholder’s Value
WACC

Figure: Minimum Level of WACC where shareholders’ value will be maximum

Original Concept by: Laurens Tijdhof – Senior Consultant, Zanders, Treasury and Finance
Solutions

As we are familiar with the rating category and WACC, now we can deal the situation of
Deluxe Corporation. For Deluxe Corporation, we have computed the cost of capital in three
different ways. And all three scenarios gave similar results. Refer to Table 1 below for the
calculations.

In the first table we have computed debt by using the book values of 2001 datas. Among all
six rating categories, “A” category has got the lowest cost of capital i.e. 4.15%. This shows
that if Deluxe Corporation maintains this grade rating then it can generate funds by paying
minimum cost of capital. As a result company can quickly reach at its breakeven and start
earning revenue.

Similarly in the second table we have calculated the cost of capital by using the market values
of 2001 datas. This is because we believe that value of equity can be determined accurately
by using the market value of share capital.

By considering the market value we can see that Deluxe Corporation can minimize its cost of
capital by maintaining the BBB category. Moving in either direction from this category will
result in increasing cost. Company will not want to go downward because declining rating
will reduce the company reputation and capacity of generating funds. But, Deluxe
Corporation cannot move above BBB rating because this would increase cost for the
company causing difficulty in maintaining its break even position.

Further in the third table we computed the cost of capital using the cost of debt of the market
data. The cost of debt is computed from the current rate prevailing in the market. This
computation gave the same result as given by the market value data of 2001 i.e. (calculation
of table 2).

Finally we can conclude that Deluxe corporation can generate its fund in lowest cost if it
maintains A or BBB rating category.