Case Study- Hill Country Snack Foods Co.

Financial Management Case Study: Hill Country Snack Foods Ltd. M/s Hill Country Snack Foods is engaged in manufacture, marketing and distribution of variety of snacks. The company is on high growth, which is driven by its efficient operations, quality products, strong position in a region that was experiencing both population and economic growth, and its ability to expand its ability to expand beyond its aisle viz. into sporting events, movie theatres and other leisure venues where consumers were more likely to purchase snack foods. Company’s corporate culture was driven by very simple mantra: Maximising shareholder value. Current capital structure of the company comprised of 100% equity (and zero debt) and growing cash position approx.. equal to 18% of total assets and 13% of market capitalization.. Further, Management insiders held approx.. 1/6th of the 33.9 million shares. Thus, the focus on building shareholder value was also personally beneficial to the members of the management team. Management believed strongly in efficiency improvement and controlling costs and was highly cautious and risk averse. This caution and risk aversion was reflected in the financial structure of the company in that the management had strong preference for equity finance and against debt finance. Debt was avoided, investments were funded internally and the company held large cash balances to increase both safety and flexibility. Key Facts: Sales had increased at a steady rate and stands at $1364.6 mn for FY2011. Return on asset at 10% and Return on equity 12% in 2011. Dividends paid is $28.8 mn and Dividend per share during Fy 2011 was $0.85. Cash and Cash Equivalents during FY 2011 was $181.1 mn, which is approx.. 13% of the annual sales. Total Owner’s equity (book value) is $780.1 mn during FY2011. Difficulties: 1. Company’s cash position and conservative capital structure had a negative impact on its financial performance measures. 2. Return on assets was reduced by company’s large cash balances. 3. Members of the investment community unhappy over the company’s excess liquidity and lack of debt finance. Present Question: Now Mr. Howard Keener, CEO of the company for last fifteen years, who has is chiefly behind the current corporate culture of being risk averse and conservative in terms of the company’s financial structure is due to retire soon, major speculation is that a more aggressive capital structure might be implemented in the near future. And the major question under contemplation is “What is the optimal capital structure for Hill Country Snack Foods, and how large are the payoffs associated with a change to a more leveraged capital structure” Thus, in the current assessment we have tried to answer the above question.

Assessment: First we have tried to calculate Cost of Capital at three different Debt to Capital Ratios: (1) 0%, (2) 20%, (3) 40%, (4) 60%. Following data is made use of: (1) Yield to maturity on 10 year maturities: 1.8% (2) At 20% Debt to Capital ratio the assumed bond rating is AAA/AA and the interest rate is 2.85%, at 40% Debt to Capital ratio the assumed bond rating is BBB and the interest rate is 4.4%, and at 60% Debt to Capital ratio the assumed bond rating is B and the interest rate is 7.7%. The debt issued has a maturity of 10 years. (3) The corporate income tax rate is 35.5% (a) 0% Debt to Capital Cost of Debt is zero Cost of Equity: Risk free rate + B(Risk Premium); where, B=Levered Beta B=B1[1+(1-t)(Debt/Equity)]; (where, B1= Unlevered Beta) Since in the present case, Debt is zero, B=B1 Since B1 is not given, we assume it to be 1 for the current situation and other following situations. Thus, cost of equity is 3.8% (10 year maturity Bond Yield of bonds issued by A rated companies. Here we assume M/s Hill Country Snacks Foods Co. to be A rated, in absence of any particular assigned rating to the company.) WACC= 3.8% (b) 20% Debt to capital B=B1[1+(1-t)(Debt/Equity)]; (where, B1= Unlevered Beta) B=B1[1+(1-0.355)(145/580)] B=1.16 (B1 is assumed 1, Debt is $145mn, Equity is $580mn, Corporate tax rate (t) is 35.5%) Cost of Equity: Risk free rate + B(Risk Premium); where, B=Levered Beta Cost of Equity= 1.80+1.16(2.85-1.8) Cost of Equity= 3.018 Cost of Debt= 2.85% WACC= Cost of Equity [Equity/(Debt+ Equity)] + Cost of Debt (1-t) [Debt/ (Debt+Equity)]

WACC= 3.018[0.80]+2.85(1-0.355)[0.2] WACC= 2.78 (c) 40% Debt to Capital B=B1[1+(1-t)(Debt/Equity)]; (where, B1= Unlevered Beta) B=B1[1+(1-0.355)(290/435.1)] B=1.43 (B1 is assumed 1, Debt is $290mn, Equity is $435.1mn, Corporate tax rate (t) is 35.5%) Cost of Equity: Risk free rate + B(Risk Premium); where, B=Levered Beta Cost of Equity= 1.80+1.43(4.4-1.8) Cost of Equity= 5.518 Cost of Debt= 4.4% WACC= Cost of Equity [Equity/(Debt+ Equity)] + Cost of Debt (1-t) [Debt/ (Debt+Equity)] WACC= 5.518[0.60]+4.4(1-0.355)[0.4] WACC= 4.446 (d) 60% Debt to Capital B=B1[1+(1-t)(Debt/Equity)]; (where, B1= Unlevered Beta) B=B1[1+(1-0.355)(435/290)] B=1.48 (B1 is assumed 1, Debt is $435mn, Equity is $290.1mn, Corporate tax rate (t) is 35.5%) Cost of Equity: Risk free rate + B(Risk Premium); where, B=Levered Beta Cost of Equity= 1.80+1.48(7.7-1.8) Cost of Equity= 10.532 Cost of Debt=7.7% WACC= Cost of Equity [Equity/(Debt+ Equity)] + Cost of Debt (1-t) [Debt/ (Debt+Equity)] WACC= 10.532[0.40]+7.7(1-0.355)[0.6] WACC= 7.1927 Conclusion: Thus, we have seen from above, that Cost of Capital is minimum at 20% Debt to Capital. Further, introduction of 20% Debt in the capital structure would provide following benefits: (i)

The firm would be able to improve the profitability position and thus shareholder value due to reduced tax outgo on the interest expenses.

(ii)

Further, since the interest rate is comparatively very small as compared to the dividend rate, there is reduction in net outgo to the shareholders which would improve the capital position of the firm. Introduction of debt would add to Culture of Discipline in management.

Submitted By: Saurabh Agarwal, G16045, GMP (2016-17)