Company Background

Hill Country Snack Food (HCSF) is a company that manufacture, markets and
distributes a variety of snacks such as pretzels, tortilla chips and frozen treats. HCSF also
offered more traditional snacks foods which are purchased by customers thousands of times a
day in wholesale clubs, convenience stores and supermarkets. Its efficient operations, quality
products, strong position in a region make the company growth and success. Its ability to
expand into different markets makes HCSF experiencing both population and economic
growth.

Executive summary

Hill Country Snack Food (HCSF) is a company that manufacture, markets and
distributes a variety of snacks such as pretzels, tortilla chips and frozen treats. HCSF also
offered more traditional snacks foods which are purchased by customers thousands of times a
day in wholesale clubs, convenience stores and supermarkets. Its efficient operations, quality
products, strong position in a region make the company growth and success. Its ability to
expand into different markets makes HCSF experiencing both population and economic
growth.

Hill Country was a well-managed company, where all decisions were made according to
one criterion. For the past 15 years, Hill Country Snack Foods was managed by Howard
Keener. Howard Keener believed shareholder value can be maximized if management do
their jobs. Keener and members of management team held one-sixth of the 33.9 million
shares outstanding of HCSF and its show that Keener and management team focus on
maximizing the shareholder value. Strong commitment to efficiency and controlling costs is
also a component of company culture established by Howard Keener. Operating and capital
budgets were lean and aggressive, and Keener actively involved in both budget approval
process and in ensuring the business was managed to the numbers in the budget. Caution and
risk aversion is another important culture made by Keener. Keener as risk-averse kind of
investor make the budget and activities performed by the company based on this culture. Due
to the this corporate culture established by Keener, he set the tone at the top all the way down
to the bottom of the organization. The company make low risk bet and avoided great leaps in
its product markets. The management was contented with steady growth rate of the company.

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Growth was low risk and incremental, driven by extensions of existing products and
acquisition of smaller specialty companies. Company believed a series of small but
successful product launches, combined with the companys operating and cost efficiencies
would contribute positive operating profits. The company was managed with strong
preferences for equity finance and against debt finance. Large cash balance was held by
company for safety and flexibility.

Based on Exhibit 1, company consistently produced strong financial results for

the past years. A decrease in earning had been experienced by company in 2007. Company
struggled to increase profitability in 2008 but growing sales and continued attention to costs
drove large increase in net income since the recession ended in 2009. For the past years return
on asset and return on equity increase equally with return on asset reaching 10% and return
on equity exceeding 12% in 2011. Continuous and growing dividend was paid by Hill
Country Snack Foods since the companys cash flow was sufficient to fund both capital
investment and dividend payments to shareholders. Management planned to maintain
dividend payout ratio below 30% of net income. Though the company had a good cash
position and conservative capital structure, however it had a negative impact on its financial
performance measures.

What Is The Current Situation Of The Company?

In the late January of 2012, Howard Keener was asked about the companys cash balances,
capital structure and performance measures. One investigator grumbled that Hill Country's
developing money position, nonattendance of obligation back and huge value adjust made it
troublesome for an organization to gain a high rate of profit for value and suggested a
forceful capital structure. Hill Country was a well-managed organization where all choices
made were concurring one measure which is "wills this activity construct shareholder value?"
Howard Keener, the organization's CEO had a solid trust that administration's occupation was
to boost shareholder value.

Another critical segment in the company culture was a solid responsibility to

effectiveness and controlling expenses. Productive operations and tight cost controls were
fundamental conditions for achievement on the grounds that the organization couldn't depend
on the cost increments in this high contention industry, for example, PepsiCo. Next, this

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company practices caution and is a risk-averse. Growth was low-risk and incremental. This
strategy produced sales growth rate that were steady. Management stayed away from
incredible jumps in its item showcases, rather trusting a progression of little yet effective item
dispatches, joined with the organization's working and cost efficiencies, would rapidly
contribute positive working benefits. The companys culture of risk-avoidance was also
additionally showed in financing choices. The CEO dealt with the organization with these
convictions which is doing value back, against obligation fund since he feels that they were
fitting despite the fact that it is addressed by a few individuals from the expert.

Under the financial performance scope, the companys cautious growth strategy
also additionally permitted the organization to pay persistent and developing profits, which
considered that the organization's income was adequate to subsidize both capital ventures and
profit instalments to shareholders. Notwithstanding, it had a negative effect as well. Return
on assets was diminished by Hill Countrys large cash balances in two ways. Interest rate
earned on invested cash is barely 0% and gives almost no net income and more cash means
more total assets in the company. Return on equity was similarly reduced by the avoidance of
debt and complete reliance on equity capital. It is stated in the case study, that many investors
were frustrated by the companys excess liquidity and lack of debt finance.

The companys capital structure is with zero debt finance, which was actually
fairly unique within its industry. Refer to Exhibit 2, PepsiCos debt-to-capital ratio was 49.6%
but it earned bond ratings of Aa from Moodys and A from Standard and Poors due to
its strong interest coverage and low level of business risk. Based on Exhibit 2, we can see
that the earnings per share for PepsiCo is higher than Hill Country with $4.08 compared to
$2.88 respectively. Even though the PepsiCos debt-to-capital ratio is higher with 49.6%, it
gives higher net profit margin of 9.7% to the company compared to zero debt-to-capital with
only 7.2% net profit margin for Hill Country. We know that Hill country is unleveraged firm
which practiced 100% equity but in fact, its return on equity is only 12.5% which is lower
than PepsiCo with 30.8%.

In this way, with a specific end goal to expand the extent of debt in the
association's capital structure is by issuing debt to subsidize a substantial exceptionally
planned profit through a stock repurchase. Slope Country additionally can issue obligation
with implanted alternatives, for example, callable bonds, empowering the firm to purchasing
back bonds at a specific cost when debt financing is unfavourable. In the event that the

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management is still worried about rising debt levels would prompt to weaker money related
reports, other capital assets, for example, off-balance sheet financing can change the capital
structure without much dynamic and unfavourable change of the critical monetary
proportions, accepted debt-to-equity proportion and interest coverage ratio, which have a
solid effect onto the assessment of Hill Country's risk level.

HCSFC Performance And Proposed Capital Structure Analysis

Hill Country Snack Foods Company (HCSFC) has using internal equity financing over debt
financing in the firms financing. Although the firms sales, profit and growth has been
steady, but due to the rapidly changing marketplace and higher rate of return on equity (ROE)
that are required, HCSFC needs to adjust their capital structure to maintain competitive in the
market. Their current capital structure is negatively impact their financial measures that
viewed negatively by shareholders. HCSFC must select a more aggressive capital structure to
take advantage on the low interest rate environment and to marked companys strength to the
market which later then will increase share value. Capital structure adjustments not only
benefit the company, but it also will benefit the shareholders and management team who have
majority of company shares.

In 2011 based on exhibit 1, it can be seen that HCSFC have a high liquidity based
on the short term solvency ratios. When it comes to current and quick ratio, HCSFC
outperformed its competitors namely Snyders Lance (SL) and a giant company, PepsiCo
(Pepsi). HCSFC outperformed both SL and Pepsi due to its current capital structure that
100% depend on equity, while its competitor, SL and Pepsi were both using debt financing in
their capital structure and this could be the reason why they have a lower current and quick
ratio as compared to HCSFC. In the past, by having a huge amount of cash and also a huge
chunk of cash equivalent were advantageous to HCSFC. However now, with an earning that
barely pass over 0%, those method or strategy that they used before can no longer increase
their profit and elsewhere, it might earned higher return. Besides that, it can also be seen that
HCSFC asset management strategy loss its touch where the total asset turnover of HCSFC
keep on declining every year for the past 5 year and this shows that the company no longer
efficient in managing its asset and it is due to the fact that the firm capacity have reach its
limit. This is a serious matter and should be observe closely even though the ratio is still
higher compare to its competitor that is SL and Pepsi.

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 Based on exhibit 1, the net profit margin, ROA and ROE of HCSFC decline in
2007 and 2007 and this is due to the recession that occurs during that time. However, once
the economy improve the profitability of the company rise up again steadily. Even though the
net profit margin of HSCFC increases in 2011, the company only manage to beat SL.
However, when it comes to ROA and ROE in 2011, the HCSFC managed to beat both of its
competitors that is SL and Pepsi. Thus, this shows that HCSFC operate efficiently as
compared to both of its competitors (SL and Pepsi). It can be seen that in 2011, HCSFC were
managed effectively and well position for profitability through the improvement made and
also a strong ratios that were shown.

Back in the past, looking at HCSFC growth, the company experience a weak
annual growth rate of net income in 2007 and 2008 even though the company appear to have
a steady topline growth. Due to this, the 5 year compounded annual growth rate of net income
is greatly affected where the growth rate is almost half of its competitors which is SL. The
main cause of this is due to the fact that recession occurs during that time and also due to the
companys strategy that prefer slow and steady growth. HCSFC future growth prospect will
be promising if they can maintain their annual growth rate of net income for the next last 3
years. When it comes to debt to equity ratio, due to the company internal financing policy,
HCSFC debt to equity ratio have remained consistent and low. HCSFC could assume and
utilize debt while keeping their cautious and risk adverse managerial philosophy as the
company find out the three reasons that encourage them to take debt which is high taxable
income, high percentage of tangible assets and high certainty operating income.

When it comes to the performance of the company in term of sales, SL

performance in sale is a bit higher than HCSFC but as a whole, both SL and HCSFC sale
almost similar. However, when compare with Pepsi, the company performance in sale is
amazing given the size of the company which is gigantic where the sale made by Pepsi is 47
times more than HCSFC but given the size of HCSFC, the company is performing well. Both
SL and Pepsi have a debt to capital ratio of 23.5% and 49.60% and as for HCSFC, the
company doesnt take debt financing. Profitability is also one of the most important parts that
a company usually look at in order to know whether they making a profit or loss and net
profit margin ratio are used as an indicator. Based on exhibit 2, it can be seen that HCSFC
able to control and manage its cost efficiently which make it profitable as its net profit margin
is 7.2%. While compare to SL, SL net profit margin is only 2.3% which is much lower than
HCSFC and this is due to the relation of equity.

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 However, when compared to Pepsi, HCSFC falls behind in term of profitability
where Pepsi net profit margin is 9.7% and the main reason that can give Pepsi a high net
profit margin is due to its buying power and gigantic size. Another reason is due to HCSFC
decision on to do both things in one that to fund growth and at the same time paying
dividends and to do this, the company retain its cash. In 2011, HCSFC maintain its dividend
payout ratio at 29.5% in order to make sure that it can fund the growth and at the same time
paying a divided. Compared to its competitor, Pepsi gives out about 49.7% as dividend
payout ratio while SL gives out an unsustainable dividend payout ratio of 112.6% in 2011. In
exhibit 2, it can be seen that the growth rate is sustainable at 8.8% for HCSFC and this
number is currently higher compared to its 5-year compounded, while the growth rate of
Pepsi is sustainable at 15.5% and for SL, the growth rate is not sustainable due to negative
value. Based on analysis above, it can conclude that HCSFC rank the highest among its
competitors (SL and Pepsi) in term of ROA (10%) and asset turnover (1.39) but ranked in the
second place among the group in term of ROE. Exhibit 3 shows the comparison between
HCSFC, SL and Pepsi in term of ROA and ROE in the relation to their net income.

When a company decided to use its debt in order to purchase back their stock, the
debt can no longer be used to generate growth. The possibility that a stock price will increase
is high if the company take an action by reducing its number of shares in order to concentrate
the firms value. By buying back the stock, it will create a high book ratio even though by
purchasing back the stock will reduce the book value of the company. In other words, by
buying back the stock, it will not eliminate or destroy it but rather create a value for it. Given
the current situation of HCSFC which operate full on equity with no debt financing that have
reach its limit; it is important to for HCSFC to choose an optimal capital structure that
benefits it especially it is the first time HCSFC want to consider using a debt. In order to
identify the optimal capital structure of HCSFC, three type of capital structure have been
analysed as shown in exhibit 4.

Based on exhibit 4, if HCSFC took a capital structure that consists of 20% debt to
equity (D:C), the result will only impact the company moderately. Furthermore, due to small
amount of debt used that is 20%, the tax saving or also known as tax shield effect will be
small and this small amount of tax saving cannot counterbalance the interest expense of the
debt. By only using 20% of debt to repurchase the stock, the firm can only buy a small
number of shares outstanding. As a result, will give a moderate EPS, dividend payout ratio
and total value to a single shareholder as the net income needed to be distributed to large

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amount of shares outstanding that is left. Even though with 20% D:C, the company is slated
to receive a AAA rating with a given rate of 2.85%, it is not an optimal capital structure
for HCSFC.

On the other hand, if HCSFC choose a capital structure that consists of 60% of
debt to equity (D:C) with an objective to purchase back its stock nearly 28% of the
outstanding shares give that the premium of buying back the stock which is 25%, the
company will be slated to receive B rating with a higher interest rate of 7.7% due to a
higher risk because of high debt. Based on this situation, it will give HCSFC interest
coverage of 4.5. More than that, at 60% of debt, the net income of HCSFC would drop
drastically as compared to 20% of debt where the net income is $76 million (60% debt net
income). Furthermore, due to the fact that the debt is high, the interest expense of the debt is
also high and even though the tax saving receive will increase by $11.8 million, but the
amount is not sufficient to offset a high amount of interest expense worth $33.5 million. Due
to a lower net income, EPS, dividend payout ratio and total value to single shareholder will
be also lower as compared to 20% debt to equity capital structure even though the number of
shares outstanding decrease by a lot. Graph 1.1 below show the comparison of net income,
interest expense and EPS for 20% D:C, 40% D:C and 60% D:C.

Graph 1.1: HCSFC net income, interest expense and eps for different capital structure.

HCSFC 's net income, interest expense and EPS

100 94.9 40
89.3
90 33.5 35
80 76
30
70
60 25
Net Income EPS Interest Expense
50 20
Dollar ($) Dollar ($)
40 12.8 15
30
10
20
4.1
3.19 3.31 3.11
10 5

0 0
20% D:C 40% D:C 60% D:C

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 Based on the analysis, it can be seen that, in 20% and 60% debt to equity capital
structures, shows a reduction in EPS, dividend payout ratio and total value to single
shareholder. Due to these findings, a 20% and 60% debt to equity capital structure is not
recommended for HCSFC. A capital structure with 40% debt to equity is the best capital
structure recommended for HSCFC and this is due to the fact that the interest coverage ratio
under this capital structure is very strong with a value of 11.8 which mean that the company
have a high ability to meet its interest payment with ease. Furthermore, the tax saving form
using 40% of debt help in counterbalance the interest expense of the debt and this will gives a
result of a small drop in net income to $89.30 million which is still higher than the net
income in 60% debt to equity capital structure. The dividend of the HCSFC will increase
moderately and this will allow the company to retain cash in order to continue funding the
growth of the company. Additionally, large amount of net income will increase the EPS to
$3.31 per share which will also increase the total payout to $39.60.

Based on the exhibit 4, we used the EBIT modifier in order to test the changes of
EBIT toward the three proposed capital structures which is 20% D:C, 40% D:C and 60% D:C
in term of net income, EPS, dividend payout ratio and total payout to a single shareholder.
Based on the analysis, it is confirm that under 40% debt to equity capital structure, even with
a decrease of EBIT by 20%, the net income of HCSFC still remain strong which mean that
the company can still give out dividend towards its shareholder. As s conclusion, in order to
ensure that the HCSFC experience more benefit or advantages, a capital structure of 40 % of
debt to equity is the most suitable for HCSFC as this capital structure will ensure that the
company does not bear excessive debt than they can afford to gain maximum profit and
increase the shareholder value, which then will help to support the managements team..
Furthermore, it will increase the shareholder value which is also in line with what the
company hope so and last but not least, it will signal the other competitor that HCSFC has
begun restructure its capital structure in order to be more competitive and strong and also
signal its competitor regarding the company prospect of growth moving toward the market.

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ADVANTAGE AND DISADVANTAGE OF DEBT FINANCING

One of the primary preferences of Debt Financing is that it permits the

founders to hold responsibility for organization. The high authorities hold
the control of the organization and there is no outsider required in the
same. Whatever choice is made, it is by the organization and for the
organization with no outside opinion being included. It furnishes
independent venture proprietors with a more noteworthy level of money
related flexibility. Additionally, if an independent company or organization
can pay its debt with enthusiasm on time, it is less demanding for the
organization to procure money related help at whatever point required
later on. Using debt to fund a business is extremely valuable for private
company and organizations since it should be possible on a fleeting
premise also to complete short operations. Once the errand is done, they
rising organization can pay back what it needs to and push ahead towards
more noteworthy undertakings.

This aides in the advance of organization in more routes than

one. Whenever a business has utilized debt to back its undertakings, they
ensure each and every piece of their assets are used and if they didnt
manage to ensure that every piece of their asset is fully utilize, they wont
be able to pay back the debt that they have taken. Thus this will ensure
that they will work harder in order to pay the debt back. Utilizing all the
accessible assets and effectively is one of the significant worry in business
advancement. The loan specialist to the business/organization has no
future claims on the income of the organization. Once the debt alongside
the intrigue has been paid back to the loan specialist, the bank has no
connection what so ever with the organization unless generally began
again by the organization for more obligation financing. This ensures
future profit of the organization are secure.

The primary inconvenience of obligation financing targets

independent companies. With the business simply coming into the market

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and attempting to set up itself, it needs cash for which they utilize debt
financing to work. When they are done, it gets to be troublesome for them
pay back the moneylender as there are different operations to be finished.
Independent companies have a great deal of money surge when
contrasted with inflow particularly at the outset. If the obligation is not
paid on time, numerous loan specialists charge an overwhelming expense
and there is a plausibility of cancelation for future obligation financing to a
similar business/organization. Any lenders would want to debt fund a
business that is pleasantly settled so they are certain of recovering their
cash and on time. It gets to be troublesome for the independent venture
to back them through debt. As talked about before also, it might get to be
troublesome for the private venture to either pay back on time or even
pay back everything i.e obligation plus fund back to the loan boss on time.
In this way, they need to approach and oversee different assets for a
similar which again is not a simple undertaking remembering the business
itself is attempting to set up itself in the developing business sector.

Conclusion

As a conclusion, in order to ensure that the HCSFC experience more benefit or advantages,
the company must adding debt in their capital structure. By adding debt, it will give signal of
strength to the market when value goes up since shares become more attractive. Dividend to
shareholders also increases when the company is adding debt to their capital structure. Based
on the proposed plan, a capital structure of 40 % of debt to equity capital is the most suitable
for HCSFC as this capital structure will ensure that the company does not bear excessive debt
than they can afford to gain maximum profit and increase the shareholder value, which then
will help to support the managements team. Based on the analysis, a 20% and 60% debt to
equity capital structure is not recommended for HCSFC. Due to small amount of debt used
that is 20%, the tax saving or also known as tax shield effect will be small and this small
amount of tax saving cannot counterbalance the interest expense of the debt. Capital structure
that consists of 60% of debt to equity capital is exceeding the optimal debt ratio. When
company borrowing too much debt, the present value of interest expenses and others cost
rises at an increasing rate. When interest expenses increase the EPS will decrease. Borrowing

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too much also can lead to financial distress and make the stock price decrease. Based on the
analysis we can concluded that taking debt will give advantages to the company but too much
debt can make value of company decrease, effect of higher costs.

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