Case Study: Hill Country Snack Foods Co.
Hill Country Snack Foods Co. is located in Austin, Texas. It has been manufacturing a
variety of more traditional snacks that consumers favor. So, it distributed products to
different locations around the country at the convenience stores, supermarkets, retailers, and
distribution outlets. The company has enjoyed huge growth in the market due to the increased
demand for the products.
It has been enjoying huge success due to many factors such as economics, operations
efficiency, quality products, strong position in the market. On the other hand, the company
has not leveraged its position into capital structure. So restructuring would require some
analysis of the situation. So, it is a concern for the company that it has not been able provide
or improve the rate return for the shareholders due to excess cash position, and absence of the
debt.
It is a concern for the company how should it restructure the capital, should it increase the
debt-to-capital ratio 20%, 40%, or 60% which one capital structure would be feasible for the
company that is also suitable as per the industry? So, it is imperative for the company to it
should improve the rate of return, and improve its position but the issue is major what should
be capital structure since each option has many complications and implications, and how
should the company deal with these issues, which capital structure should it adopt to address
key problems and challenges.
Question 1
The operating leverage effect ratio of the company is 2.16 that indicates that operating
leverage exists into the company and the large portion of the company’s costs are fixed.
Because the ratio is greater than 1. If it equal to the 1 then it could be interpreted that majority
costs of the company is variable. Similarly, it can be interpreted that a small decrease into the
revenues would have large effect on the net operating income of the company. So, this is high
business risks for the company. On the other hand, the financial leverage effect ratio of the
company is 1.55 which shows the effect of increasing or decreasing operating income on the
net income.
So, it can be determined that if the if operating income of the company increases by 10%
then net income of the company would increase by 15.5%. Similarly, the total leverage risk
for the company is 3.34 which means that if company has sales of $100,000, and its operating
leverage is 10% then the net income of the company would increase by 33400 for each sales
of $100,000.These are the quantitate business risks. So, qualitative risks for the company are
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the rising competition, rising costs of doing business, and inefficiency into the operations. So,
it can be determined that company has low business risk, because it has been operating
effective into the market has ability to compete with the competitors.
Financial Risks
Financial risks of the company is not much higher since it does not have debt. The financial
risks refers to the risk that shareholders would lose the money invested into the company. So,
the debt to capital ratio of the company actually is 0, but as the company increases it debt by
20% then its ratio is 0.2, and other alternatives 0.4, and 0.6. See exhibit 1so, it can be
determined that company has no debt actually so it has less financial risk. On the other hand,
it is in core value of the company that creating value for the shareholders, and one sixth of the
shares are held by the company’s management that is good posture for the shareholders and it
also eliminates principal-agent problem giving trust to shareholders, and this also emphasize
on the value creation for the shareholders.
Value of the Shareholders
The share price in 2011 is $41.67, and dividend per share 0.85 in 2011. So, if the company
recapitalize the structure then it would have effect on the price per share. So, the if the
company has debt-to-capital is 20% then its share price would be $48.99, and if debt-to-
capital is 40% then its share price would be $52.48 and if the debt-to-capital of the company
is 60% then its share price would be $54.36.
Question 2
It is recommended that debt to capital ratio for the company should be 40%. Because, the
company do not have debt which makes it expensive, and financial leverage is also important
for the company for aggressive capital structure. 40% debt to capital is a balanced capital
structure of the industry. There would be numerous advantages of adding debt to the capital
structure such as the
Ownership control
Easy to operate and administrate
Tax advantage
Cost reduction
Profit retention and
Financial leverage
So, these are benefits of employing debt into the capital structure of the company. However,
being highly leveraged means high risk that makes company more risky, and increases
concerns of the shareholders. So, it can be determined that there are many complications that
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needs to be understood as being highly leverage is not good for any company. So, the balance
capital structure is preferable. Furthermore, the debt has positive impact on the taxes since
company would have tax advantage because the interest is tax deductible, but the expected
financial distress cost refers to inability of company meeting with the obligations
Hill Country Snack Foods, located in Austin, Texas, manufactures, markets, and distributes
snack foods and frozen treats. The CEO is passionate about maximizing shareholder value
and believes in keeping tight control over costs and operating the business as efficiently as
possible. The company invests in additional capacity and new products only when attractive,
low-risk opportunities are identified and can be funded internally. The firm's culture of risk
aversion extends to financing decisions with a clear preference for equity finance over debt
finance. The CEO believes a strong balance sheet with large cash balances provides the
company with maximum safety and flexibility. Sales growth has been steady but
unspectacular. As the CEO approaches retirement, investors and analysts speculate that the
company will change to a more aggressive capital structure. Students must analyze the firm's
current capital structure, explore three alternatives using debt finance, and determine the
optimal debt-to-capital ratio.
Recap: Hill Country Snack Foods Co. (HC) has been an all equity-financed company with a
debt-to-capital ratio of 0%. Its corporate culture is characterized by caution and risk-
aversion whereas increasing shareholder value has been one of HC’s most important
objectives. Following recommendations given in Questions 1 – 3, HC should implement a
more aggressive capital structure.
By adapting a more aggressive capital structure, i.e. increasing leverage, HC can take
advantage of low interest rates. Seen as Keener (and most probably his successor as well)
own shares themselves, an increase in shareholder value has to be a strong argument to
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convince the CEO. Furthermore, adding debt will give a signal of strength to the market
when value goes up since shares become more attractive.
To persuade Keener, one could argue that implementing more debt to HC’s capital structure
will reduce financing costs and create tax shields (due to interest deduction HC can then
benefit from tax savings). Thus, by using debt HC would also be able to reduce the use of
equity and increase the profit retention within the company.
Finally, there will be a positive reaction from the markets driven by the fact that the bonds
will still be considered safe (BBB rating with 40% D:C) and shareholders will gain benefit
from an increase in dividends.
“[…] a firm should increase debt until the value from PV (tax shield) is just offset, […], by
increases in PV (costs of financial distress)” 1, i.e. that there is an optimal point of how much
money a firm should borrow.
With the already presented advantages one could be able to convince the CEO of a new
capital structure. But one should not exaggerate with borrowing too much debt, i.e. one
should be aware of not exceeding the optimal debt ratio which would be at highest 40% (as
shown in the question 2). Otherwise the interest expenses increase, and thus would lead to
decreased EPS. Since exceeding the optimal debt ratio can lead to financial distress, the stock
price would decrease.
In conclusion we can say that taking debt is always advantageous until reaching the optimal
debt ratio.
Question 4: Considering Hill Country’s corporate culture, what arguments could you use to
persuade CEO Keener or his successor to adopt and implement your recommendation?
References
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1. Brealey, Myers, Allen: Principles of Corporate Finance (10th Edition): p. 379, 1: 466 -
468, 484 - 490
2. 28C00100_lectures_whole_package_2013
3. http://highered.mcgraw-hill.com/sites/0072467665/stud ent_view0/chapter18/
4. http://campus.murraystate.edu/academic/faculty/lguin/F IN330/Optimal%20Capital
%20Structure.htm
5. http://www.investopedia.com/exam-guide/cfa-level-1/corporate-finance/debt-effects-
capital-structure.asp
