Hill Country Snack

Foods Co.

Atif Raza Akbar (B17012)

Hill Country Snack Foods Co. Atif Raza Akbar (B17012)

Case background

Hills Country Snack Foods is a fairly successful company, operating out of Austin,
Texas involved in manufacturing, marketing and distributing a variety of snacks
ranging from tortilla chips, salsa, pretzels, popcorn to crackers, pita chips and frozen
treats. We look at Hill Country in the context of January 2012, when the then-CEO
Howard Keener was about to retire.

Keener was a strong believer in the philosophy which stated that the management’s
job was to maximize shareholder value. This philosophy was applied at every level
of the organization and in all operating decisions. In competing with industry giants
like Pepsico and other smaller companies, Hill Country had maintained very lean
operating and capital projects and had brought down cost variances so that they could
keep all costs under control. Keener’s philosophy manifested in risk aversion in
financing decisions as well as product strategy. The balance sheet of the company
was strong with zero debt and a large cash balance ensuring safety and flexibility.

But the same philosophy which favoured equity completely over debt, was viewed
unfavourably by certain financial analysts within and outside the organization.
Ratios such as return on assets and return on equity suffered because of the large
cash balances and a total dependence upon equity for financing. At the time of the
writing of the case, Keener was about to retire and there was speculation about
changes in the capital structure of the company. The case presents us with pro-forma
prediction of the financial numbers in case the capital structure of the company was
to become more aggressive and favourable towards debt financing.

Critical Financial Problems

1. A debt-free, risk-free philosophy might not always be rosy

The fundamental problem that ails the organization is that of philosophy.

Keener has been a staunch believer in the philosophy of maximizing
shareholder value which he translates to mean taking on as less debt as
possible (0% at the time of the case) and maintaining high cash balances (18%
of total assets and 13% of market capitalization of the firm) in order to stay
clear of “trouble”. This rigid mindset has meant that the company has lost a
lot of flexibility on major fronts.
Hill Country Snack Foods Co. Atif Raza Akbar (B17012)

2. High dependence on equity - go for debt?

Choice between debt and equity is always confusing as both come with their
pros and cons. Thus, it becomes extremely critical for a firm to evaluate the
merits and demerits of both the methods of financing before concluding on
the method best suited for the organization.

Since the culture at Hill Foods is of risk aversion they have shied away from
debt financing till now. All of their expansions have been funded by internal
funds primarily by the huge cash pile that they have earned and saved over
the years. Cash pile can act as a war chest and signals safety and flexibility
but it is adversely affecting the key financial ratios such as return of equity
and return on assets which have been very low over the years.

3. How much debt percentage should Hill Country go for in case they go for
a restructure?

Since debt funding is less expensive than equity should the company go for a
highly aggressive capital structure or a moderate one where the proportion of
debt is lesser. The interest levels in 2012 were unprecedentedly low with the
10-year treasury bonds offering at 2% and the long-term corporate bonds with
“A” rating at 3.8% The various options available were-

Debt-Capital Ratio
20%
40%
60%

Debt is less expensive due to its contractual nature and due to the priority it
gets for recovering claims. Another advantage that debt has is the tax benefit
that is derived from the interest repayment of the debts.

It is crucial to compare this problem vis-à-vis a share repurchase and

evaluate which option would deliver a better shareholder value. Since the
cost of debt financing is lower than equity financing the shareholders can be
transferred the benefits.
Hill Country Snack Foods Co. Atif Raza Akbar (B17012)

4. Share repurchase

All the debt that is issued is added to the capital structure which is then
clubbed with the cash pile of $55 millions of excess cash to repurchase
common stock. Thus, it is important to evaluate the impact that the company
would have in case there is a share repurchase which is funded by debt.

Share repurchase when financed by a debt issue, can significantly change a

company's capital structure, increasing its reliance on debt and decreasing its
reliance on equity

Moreover, at each level of debt-capital ratio a different premium would be

offered to the shareholders ranging from 15% to 25%. Identifying the
premium that would be best suited for the shareholders becomes very critical
and would be cause of concern

5. Use of the sitting cash

The company is sitting at a huge amount of cash pile which is returning zero
interest value to it. This is adversely affecting key financial ratios such as
lower return on equity and lower return on assets. Therefore, options must be
explored to identify where this can be invested to give better return and in turn
offer better shareholder values.

Analysis and Interpretations:

The Capital Structure at Hill Country

Capital structure is the percentage of capital (money) at work in a business

by type. There are two forms of capital: equity capital and debt capital. Each type
of capital has its own benefits and drawbacks and a substantial part of wise
corporate stewardship and management is attempting to find the perfect capital
structure in terms of risk/reward payoff for shareholders.

Debt Financing:

Debt financing is a method of financing in which a company receives a loan

and gives its promise to repay the loan. This includes secured and unsecured loans.
Security involves a form of collateral as an assurance the loan will be repaid. If the
debtor defaults on the loan, that collateral is forfeited to satisfy payment of the
Hill Country Snack Foods Co. Atif Raza Akbar (B17012)

debt. Until now, the upper management at Hill Country, and the CEO in particular
has been against leveraging debt for financing.

Equity Financing:

Equity Capital refers to money put up and owned by the shareholders

(owners). Typically, equity capital consists of two types:

1. Contributed Capital - This is the money that was originally invested in the
business in exchange for shares of stock or ownership and
2. Retained earnings - This represents profits from past years that have been
kept by the company and used to strengthen the balance sheet or fund growth,
acquisitions, or expansion.

Currently, the firm has been operating at a 0-100 debt – equity structure
which means that all of its financing comes from the equity put up by its
shareholders. This is in stark contrast to Pepsico, a market leader which has a debt-
equity ratio of 0.496. Since Hill Country might want to move to a leveraged
capital structure it is important to evaluate merits and demerits of it. The various
capital structures are evaluated on the basis of the cost of capital(WACC).
Dividend discount model has been used to estimate WACC for all the 3
alternatives.

Weighted average cost of capital (WACC)

This is the average rate of return a company expects to compensate all its different
investors (Debt or Equity). The weights are the fraction of each financing source in
the company's target capital structure.

WACC is calculated by multiplying the cost of each capital source (debt and
equity) by its relevant weight, and then adding the products together to determine
the WACC value:

WACC = (E/V) * Re + (D/V) * Rd x (1 – Tc)

where
• Re = cost of equity
• Rd = cost of debt
• E = market value of the firm’s equity
• D = market value of the firm’s debt
• V=E+D
Hill Country Snack Foods Co. Atif Raza Akbar (B17012)

• E/V = percentage of financing that is equity

• D/V = percentage of financing that is debt
• Tc = corporate tax rate

In order to calculate the WACC we employ the Dividend Discount Model in order
to predict the Cost of Equity and then the WACC subsequently.

The Dividend Discount Model

The dividend discount model (DDM) is a procedure for valuing the price of a stock
by using the predicted dividends and discounting them back to the present value.

Di+1-Dividends per share for next year

Po-Market value of stock
g-growth rate of dividends

Growth Rate = (1 – Payout Ratio) * Return on Equity

Dividend Payout Ratio = Dividends / Net Income

As per the case we have the following information available to us

P0 $41.67
Payout ratio 30%
ROE 12.5%

Using the above formulae gives us a growth rate of 8.75%.

Di+1 is calculated by multiplying the dividend growth rate to the previous year’s
dividend.

Di+1=Do(1+g)

Using this we calculate the cost of equity

Cost of Equity = (Dividends per share for next year / Current Market Value of
Stock) + Growth rate of dividends

Ke= (D1/ Po) +g

Hill Country Snack Foods Co. Atif Raza Akbar (B17012)

After we get the cost of equity we use the formula for WACC to calculate the
WACC.
The cost of debt is assumed as follows-

At 20% debt-to-capital the assumed bond rating is AAA/AA and the interest rate is
2.85%, at 40% debt-to-capital the assumed bond rating is BBB and the interest rate
is 4.4%, and at 60% debt-to-capital the assumed bond rating is B and the interest
rate is 7.7%. The debt issued has a maturity of 10 years.

The corporate tax rate is 35.5%. Applying the Dividend Discount Model, Cost of
Equity and then WACC is calculated as shown in the table below.

Debt as % of capital 0% 20% 40% 60%

Di 0.85 0.96 0.99 0.93
Di+1 0.92 1.04 1.08 1.01
Di+1/P0 0.0222 0.0218 0.0216 0.0194
Cost of Equity 10.97% 10.93% 10.91% 10.69%
Cost of Debt 0% 2.85% 4.40% 8%

WACC 10.97% 9.11% 7.68% 7.26%

Advantages of Debt Compared to Equity

 The lender does not have a claim to equity in the business, debt does not
dilute the owner's ownership in the company.
 A lender is entitled only to repayment of the agreed-upon interest plus
principal of the loan, and has no direct claim on future profits of the
business. If the company is successful, the owners reap a larger portion of
the rewards than they would if they had sold stock in the company to
investors in order to finance the growth.
 Except in the case of variable rate loans, principal and interest obligations
are known amounts which can be forecasted and planned for.
 Interest on the debt can be deducted on the company's tax return, lowering
the actual cost of the loan to the company.
 Raising debt capital is less complicated because the company is not required
to comply with state and federal securities laws and regulations.
 By restructuring to a 20% debt-to-capital, 40% debt-to-capital, and 60%
debt-to-capital structure, Earnings per share increased from $2.88 to $3.19,
$3.31, and $3.11 respectively. Dividends per share also increased from $0.85
to $0.96, $0.99, and $0.93 respectively.
Hill Country Snack Foods Co. Atif Raza Akbar (B17012)

Final recommendations

 Considering the WACC calculated above for the three alternatives, the lowest
cost of capital comes to be 7.26% for the alternative of 60% of debt as
percentage of the capital. Adopting this alternative would mean that Hills
Country is able to decrease the cost of capital and give the most value to its
investors and shareholders, but at a higher risk of bankruptcy. Also, if Hill
Country takes 60 % debt to capital as its target, it would repurchase more
shares as compared to the 20% and 40% debt to capital alternatives.

 Considering all factors, it appears that the 40% debt-capital alternative is the
best option for Hills Country. We also agree with the share repurchase
program as an action that adds value for the customer. The reasons are
summarized below –

o The Interest coverage ratio for the 40% alternative stands at 11.92
which is comparable to the market leader Pepsico at 11.25. This
alleviates the risk of bankruptcy that comes with the 60% alternative
while also leveraging a lower cost of capital than the 20% alternative.

o Hills Country has maintained a zero-debt capital structure for a long

time and it might be a rude shock for the organization to go from 0 to
60% debt in a short period of time. We suggest a smoother transition
period and taking a 40% debt-capital ratio as the target seems to be a
prudent approach.

o Also, at 40% debt as a percentage of the capital, Hills Country would

be able to offer $0.99 as dividend per share which is the highest of all
the alternatives, including the present structure. This matches the
shareholder maximization policy and the culture at Hills Country and
would be seen as a positive move by all the shareholders.