Hill Country Snack Food Co. FM-1
Anish Narula B17007
Anish Narula B17007
Background Hill Country Snack Food Co. located in Austin, Texas manufactures tortillas, pretzels, popcorn, churros, salsa, pita chips crackers and frozen treats. It also offered traditional snack food through supermarkets, wholesale clubs, convenience stores, and other distribution outlets. The company’s success was driven by its efficient operations, quality products, strong position in a region which was experiencing population and economic growth, and its ability to expand its presence beyond the aisle into sporting events, movie theatres and leisure events. The combination of good products, efficient and all equit y funding has produced strong financial results. Sales have increased at a steady rate. Return on assets and equity had also increased. This allowed the company to pay continuous and growing dividends to the shareholders. In 2011, cash holdings of US non-financial corporations had
increased to record levels. Hill Country displayed a similar pattern. But the unique thing about Hill Country was its zero-debt finance, particularly within the same industry. In the meantime many shareholders were of the opinion that the company would benefit from a more aggressive capital structure policy. Debt was less expensive than equity due to its contractual nature and priority claim, and interest payments were deducted from income tax purposes. Also, the interest rates at this time were at unprecedented low. So, even the investors were of the view that the company should increase its debt to equity ratio. But since the company was doing fairly well, no one was trying very hard to push the idea. So, the problem present is that, should the company change its capital structure? Or, what is the optimal capital structure for Hill Country Snacks Food?
Financial Problems 1. Zero Debt The zero-debt policy could be an outcome of the risk aversion and caution policy of the company. While its competitors had been utilising debt to fund their operations, Hill Country had never done so. In a time when market yields on 10year treasury bonds were under 2% and publicly traded 10-year bonds issued by “A” rated corporations were trading at 3.8% yields to maturity the company
Anish Narula B17007
needed to go for debt financing. This could be effectively done by buying back the shared and using debt to finance the same.
2. Large cash balance Hill Country has cash and cash equivalents to the tune of 18% of its total assets while PepsiCo’s cash and cash equivalents account for 5% of its total assets and that of Snyder’s- Lance are 0.14% of its total assets. The reason for having a high percentage of cash balance was to ensure safety and flexibility. This means that in case of any unforeseen circumstances, Hill Country would use this cash instead of borrowing and would maintain its risk averse nature of operation. This high amount of idle cash created two problems for Hill Country. One, the interest rate earned on invested cash was barely over 0% so there was no additional income being generated from this cash. So, it means that 18% of the assets were not generating any income for Hill Country. And the second was that more cash meant more total assets.
3. Large Equity Since Hill Country was entirely funded by equity, it means that the company had large outstanding equity. So, since the company’s equity was high the return on equity was low. ROE is one of the measures by which investors decide whether to invest in a company or not.
4. Management owning 1/6th of the shares The CEO and management insiders owned one sixth of the 33.9 million shared outstanding. The philosophy of building shareholder value thus would benefit company insiders as well. This could be one of the possible reasons as to why the company has been risk averse and always focussed on paying out dividends. from Exhibit 6 we can see that the five-year compounded annual growth rate of Earnings per share (8.6%) and dividends per share (13.6%) has been much higher for Hill Country than for its competitors. PepsiCo despite being a larger entity though has a higher Earning per Share than Hill Country, the CAGR is far lower. This can be attributed to the personal interests of the CEO and the Board have with respect to their holding in the company.
Anish Narula B17007
Analysis and Interpretations In order to analyse the optimal capital structure for Hill Country Snack Foods, and how large are the payoffs associated with a more leveraged capital structure, we need to find out what the optimum debt to equity ratio should be in order to maximise the returns. The different factors could be as follows a.) Weighted Average Cost of Capital b.) Interest Coverage Ratio c.) Earnings Per Share
Cost of Equity
The cost of equity is the return a company requires to decide if an investment meets capital return requirements; it is often used as a capital budgeting threshold for required rate of return. A firm's cost of equity represents the compensation the market demands in exchange for owning the asset and bearing the risk of ownership. There are two ways in which a company can raise capital: debt or equity. Debt is cheap, but it must be paid back. Equity does not need to be paid back, but it generally costs more than debt due to the tax advantages of interest payments. Even though the cost of equity is higher than debt, equity generally provides a higher rate of return than debt.
0% 20% Debt 40% Debt 60% Debt ROE 12.51 16.36 20.52 26.20
Anish Narula B17007
Cost of Debt
Cost of debt refers to the effective rate a company pays on its current debt. In most cases, this phrase refers to after-tax cost of debt, but it also refers to a company's cost of debt before taking taxes into account. The difference in cost of debt before and after taxes lies in the fact that interest expenses are deductible.
= ( 1 − ) ∗ ( )
As per exhibit 3, the interest rate of 10-year government bond was 1.8% which can be taken as the interest rate of debt, the corporate tax rate has been taken as 35.5% which can give us the cost of debt.
WACC
A firm’s Weighted Average Cost of Capital (WACC) represents its blended cost of capital across all sources, including preferred shares, common shares, and debt. The cost of each type of capital is weighted by its percentage of total capital.
The Weighted Average Cost of Capital (WACC) serves as the discount rate for calculating the Net Present Value (NPV) of a business. It is also used to evaluate investment opportunities, as it is considered to represent the firm’s opportunit y cost. =
( + )
∗ +
( + )
Where:
E = market value of the firm’s equity (m arket cap) D = market value of the firm’s debt
CoE = Cost of Equity
∗
Anish Narula B17007
CoD = Cost of Debt
0% 20% Debt 40% Debt 60% Debt WACC 12.51 13.32 12.78 11.12 Rank 2 4 3 1
As WACC is taken as the discounting factor, higher the WACC lower the valuation of the firm. Hence, we can say that the 60% debt should be the most favourable financing option followed by 0%, 40% and 20%.
Interest Coverage Ratio
The interest coverage ratio is used to determine how easily a company can pay their interest expenses on outstanding debt. The ratio is calculated by dividing a company's earnings before interest and taxes (EBIT) by the company's interest expenses for the same period. The lower the ratio, the more the company is burdened by debt expense. When a company's interest coverage ratio is only 1.5 or lower, its ability to meet interest expenses may be questionable. The ratio measures how many times over a company could pay its outstanding debts using its earnings. This can be thought of as a margin of safety for the company’s creditors should the company run into financial difficulty down the road. In our case, the interest coverage ratio are as follows:
20% Debt 40% Debt 60% Debt 11.82 4.51 ICR 36.90 Rank 1 2 3
If Interest coverage ratio is considered as a factor then 20% debt should be preferred followed by 40% and then 60%.
Anish Narula B17007
Earnings Per share
The firm has this corporate culture of enhancing shareholders’ value, which compels us to take decision which aligns with the interest of the firm, thus, higher the earnings per share, better is the option 0% Debt 20% Debt 40% Debt 60% Debt $ 3.19 $ 3.31 $ 3.11 EPS $ 2.88 Rank 4 2 1 3
A shareholder would always want higher earnings per share value as it increases its wealth. Thus, we can see that the highest earnings per share is obtained by adopting a debt-to-capital ratio of 40%.
Recommendations 1. The firm should plan to shift towards aggressive capital structure by obtaining debt in the form of low interest rate government bonds which would enhance the interest of shareholders as the firm would get tax benefit from debt as well as confid ence enhanced on company’s going concern 2. The management should look into the 18% cash balance, which can be utilized to obtain other income for firm and enhance the balance sheet through investment in high return inter-corporate market or lending. 3. The return on equity can be enhanced by obtaining the debt and restructuring the capital of the firm, which can improve the investor interest into the firm and further increasing the reputation of the firm in stock market. 4. Based on the cost of capital, we can see that the value decreases with the increase in debt structure. The interest ratio covered decreases with the increase in debt structure. Whereas the earnings per share is the best for a 40% debt-to-capital ratio. This make sus arrive at the conclusion that the most optimal capital structure of the company would be a debt-to-captial ratio of 40%.
