Hill Country Snack Foods Co.

Case Study

Company Background

Hill Country Snack Foods is a company located in Texas that manufactured,
marketed and distributed a variety of snacks, which were purchased by end
consumers in supermarkets, wholesale clubs, convenience stores and other
distribution outlets. The companys growth and success was driven by its
efficient operations; quality products; and its ability to expand its presence
beyond the aisle.

Under the leadership of Howard Keener, the companys CEO for 15 years, Hill
Country Snack Foods Co. followed an operating strategy of zero debt financing
and 100% equity finance. Following a corporate culture of risk avoidance, all
investments were funded internally. The company also held large cash balances
to increase both safety and flexibility. Another important component of company
culture was a strong commitment to efficiency and controlling costs. The main
criterion for all decisions taken by the company was whether the decision would
maximize shareholder value or not.

Business Risk stems from uncertainty about future operating income (EBIT).
Business risk is mainly affected by uncertainty about sales, prices and costs. The
companys culture of caution and risk-aversion helps minimize business risk for
the company. Being a fully equity financed company, the effect of changes in
operating income would be somewhat linear and not exacerbated due to
leverage.

Financial risk refers to the additional risk concentrated on ordinary
shareholders as a result of financial leverage. Since Hill Country Snack Foods is a
100% equity financed company, there is negligible financial risk for ordinary
shareholders.

Recommendation

As seen in the recent financial measures, the companys sales, profit and growth
rate have been stable yet due to the rapidly changing marketplace, the company
must make capital structure adjustments to remain competitive. The
conservative capital structure followed by the company is affecting the financial
measures, which is being questioned by investors and analysts. To remain an
attractive investment option, the company must adopt a more aggressive capital
structure and take advantage of the low interest rate environment.

Using the debt to repurchase stock and not to generate growth would lead to
concentrating the firms value in a reduced number of shares. This would most
likely result in an increase in stock price. Although the companys book value will
be reduced, the share repurchase would definitely create value.

Based on an analysis of the three case scenarios of capital structure, a 40% debt
to capital ratio would be appropriate for Hill Country Snack Foods. With the low
interest rate on treasury bonds, there will be high demand for Hill Country Snack
Foods corporate bonds as they would be investment grade based on the high
rating of BBB. Under this scenario, the company is found to have a strong
interest coverage ratio of 11.8 and the tax savings help offset the interest
expense. The net income would drop slightly to $89.30million. The Earnings per
share would increase to $3.31 per share. Testing changes to EBIT, it is seen that
even with decreases of up to 20%, net income stays strong. A 40% deb-to-capital
ratio structure would be highly advantageous for the company as it will make
sure the company is not over leveraged, which supports the managements
preference and it will increase shareholder value which is the main focus of the
company. Such a change to the capital structure would also send a positive signal
to the market about the growth prospects of the company.

Debt Financing

Advantages:

1) One of the main advantages of Debt Financing is that it allows the founders
to retain ownership of their company. The high officials retain the control of
the company and there is no third party involved in the same. Whatever
decision is made, it is by the company and for the company without any
external idea being involved.
2) It provides small business owners with a greater degree of financial
freedom. Also, if a small business or company is able to pay its debt with
interest on time, it is easier for the company to acquire financial help
whenever needed in the future.
3) Using debt to finance a business is very useful for small business and
companies because it can be done on a short-term basis as well for
completing short operations. Once the task is done, they emerging company
can pay back what it has to and move forward towards greater tasks. This
helps in the progress of company in more ways than one.
4) Whenever a business has used debt to finance its tasks, they make sure
every last bit of their resources are utilized. Because if they do not do the
same, they will not be able to pay back their debt with interest. Using all the
available resources and efficiently is one of the major concern in business
development.
5) The lender to the business / company has no future claims on the earnings of
the company. Once the debt along with the interest has been paid back to the
lender, the lender has no relation what so ever with the company unless
otherwise started again by the company for more debt financing. This makes
sure that future earnings of the company are secure.

Disadvantages:

1) The main disadvantage of debt financing targets small businesses. With the
business just coming into the market and trying to establish itself, it needs
money for which they use debt financing to operate. Once they are done, it
becomes difficult for them pay back the lender as there are other operations
to be done. Small businesses have a lot of cash outflow as compared to
inflow especially in the beginning.
2) If the debt is not paid on time, many lenders charge a heavy fee and there is a
possibility of cancellation for future debt financing to the same business /
company.
3) Any creditor would want to debt finance a business that is nicely established
so they are sure of getting their money back and on time. It becomes difficult
for the small business to finance them through debt.
4) As discussed earlier as well, it may become difficult for the small business to
either pay back on time or even pay back the full amount i.e debt + finance
back to the creditor on time. So, they have to approach and manage other
resources for the same which again is not an easy task keeping in mind the
business itself is trying to establish itself in the emerging market.

Tax Benefits and Costs of Financial Distress

Whenever a business or a company uses debt to finance its operations, it has an
advantage when it comes to paying the taxes. The taxes of the company are
deducted from the interest that is levied on the debt taken from the creditor. The
tax savings should be enough to offset the interest expense to gain from the debt
financing.
The most common example of financial distress is bankruptcy costs. If at all a
company goes bankrupt, the interest will still be levied on whatever money the
company has. Debt holders will have a prior claim on the cash flows of the firm
whereas the equity holders will have a residual claim.
Auditors, lawyers and managers will take their fees first in the case of financial
distress, which would decrease the residual claim of equity shareholders.




Alternative Scenarios

If the company adopts the 60% debt-to-capital ratio structure, the company
would be rated B because of the higher level of risk. This would lead to an
increase in the interest rate to 7.7%, which would result in an interest coverage
ratio of 4.5. Net income would fall, as the tax savings would not be enough to
offset the increase in interest expense.

Alternatively, if the company adopts the 20% debt-to-capital ratio structure, the
company would be rated AAA because of the low level of risk. This would lead to
an increase in the interest rate to 2.85%. The tax savings would still not be
enough to offset the increase in interest expense.