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 equity 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 10-
year 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
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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.
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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
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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.

𝐶𝑜𝐷 = (1 − 𝑇𝑐 ) ∗ (𝑅𝑑 )

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 opportunity
cost.
𝐸 𝐷
𝑊𝐴𝐶𝐶 = ∗ 𝐶𝑜𝐸 + ∗ 𝐶𝑜𝐷
(𝐷 + 𝐸) (𝐷 + 𝐸)

Where:

E = market value of the firm’s equity (market cap)

D = market value of the firm’s debt
CoE = Cost of Equity
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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

ICR 36.90 11.82 4.51
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%.
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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
EPS $ 2.88 $ 3.19 $ 3.31 $ 3.11
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 confidence 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%.