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Hill Country Snack Foods. Co Case Solution & Answer

Hill Country Snack Foods. Co Case Solution

Introduction

Hill County Snack Foods, a manufacturer, distributor and seller of snack foods and frozen items was located in Austin, Texas. The company’s Chief Executive Officer had remained passionate about maximizing the value of its shareholders through keeping a tight control over the costs and business operations. The company had been investing in only low-risk and attractive market opportunities, which were able to be funded by the internal cash position.(Kester, W. Carl, and Craig Stephenson, 2012)

The firm’s risk aversion culture was strongly embedded in the company’s capital structure, as the management always prioritized equity over debt financing. The CEO had the sound belief that the company was enjoying a maximum safety with a large cash balance and a strong balance sheet. However, in the last analysts’ meeting; few investors had pointed out towards the idea of taking a more aggressive capital approach, as the investors believed that the addition of debt would increase the shareholders’ value, ultimately.

Problem Statement

Hill Country Snack Foods’ CEO was facing a challenge while making the deciding about an optimal capital structure. The company had zero debt, as the CEO believed that excess cash was not a problem but an excessive debt was. However, while approaching towards the retirement, the CEO was questioned by the company’s investors and analysts for the adoption of a more aggressive capital structure inorder to increase the firms’ value and to maximize the shareholders’ worth.

Reason behind Taking Significant Amount of Long-Term Debt

The case facts revealed that the company is fully reliant on the equity financing and has zero debt in its capital structure. The current situation of the company indicated that the company has adopted higher cost financing, i.e. equity financing. The company‘s financial strength is comparatively better in comparison to its industry peers, due to the total absence of debt position. However, the zero debt gives an idea that the company is only facing business risk, which could negatively impact the company’s financial positions, as the company might face a negative market condition and negative economic climate. In order to reduce its business risk and to reduce its financing cost;the company should add up debt in its capital structure. The main reasons behind the addition of significant amount of debt are as follows

The industry practices indicated that the business are using debt for financing the operations. The usage of debt provides a higher return on assets, as the interest payments over debt financing are tax deductible and provide a higher profitability, ultimately higher return on assets. Debt is a cheaper financing as compared to equity financing, as the tax saving provides a chance to generates greater profitable condition.

Maximum & Stable Level of Debt

The proposed debt-to-capital alternatives included 20%, 40% and 60%. Among the three alternatives the second alternative of 40% appears to be viable option. Though the addition of debt reduces the income taxes in all the proposed options, but the inclusion of debt by 40% provides the company with an increased and highest earnings per share of $3.31. In addition, the key interest of the shareholders i.e. the dividends per share is also highest in 40% (See Appendix 1).

In addition, a firm should consider the level of debt which maximize the shareholders’ worth and minimizes the cost of wealth. The earnings per share and dividend per share with a 40% debt maximized the shareholders’ worth however, in order to find out which option minimizes the cost of capital, the weighted average cost of capital has been calculated in each case.Whereby the unlevered beta is chosen and the beta and return on equity is determined in each of the scenarios. The WACC calculation shows that the company’s cost of capital in 2011 was 7.3%, which is reduced with an addition of debt as the WACC in case of 20% debt is 6.92%, 6.93% with405 debt and 8.03% with a 60%. So, the suggested debt-to capital ratio is 40% (See Appendix 2)……………………….

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