Hill County operates in a very competitive market where new potential entrants can be a threat to its operation either through lower price offering or lower production cost. Competition from peer companies has significant effect on its operation, because Hill County is price taker in the market, that is, increase in prices is not one of the choices it can implement. Also, due to the fact that its profitability relies heavily on cost management, an intense competition can worsen the situation of Hill County in the future. Hence, the company needs to be very efficient in order to compete with other low-cost production firms. In addition, cost management may also link to the bargaining power of Hill County over its suppliers, which plays an important role in the manufacturing cost of the firm. Whenever their suppliers have more bargaining power, Hill County would face a potential decline in its profit margin. Macroeconomics conditions also contribute to the business risk of Hill County.
During an economic downturn, consumers are less likely to spend money on snacks or attend venues, where they would normally purchase snacks. This would result in declining sales. Hill County does not seem to offer as much diversification in their line of production needed, in order to diversify their exposure to macroeconomic contractions away. The change of consumer behaviour is another business risk faced by Hill County. Recent surveys have shown that, consumers tend to become more aware of Health food. This indicated that they may turn away from less healthy snacks to other choices such as organic food. Selling snacks through school systems also requires the company to alter its products. Therefore, Hill County has to conduct researches and develop alternative choices in response to such preferences and requirements, which leads to an increase of cost.
1.2 How much financial risk would the company face at each of the three alternative debt-to-capital ratios presented in Exhibit 4? The following table compare the potential financial risk faced by the company under each of the debt-to-equity ratio alternative. In general, the higher the leverage ratio is, the higher the risk level will be.
20 % Debt to Capital
40% Debt to Capital
60% Debt to Capital
The company has the same tax level across each scenario, and thus there is no difference in the relative advantage of An increase in the debt level is leading to higher The highest tax shield advantage in Tax Shield tax shield. However, in absolute terms, an increase in the tax shield benefits absolute terms to the company debt-to-capital ratio will enhance the tax shield benefit The bond rating is AAA/AA, indicating that the default risk is rather low. In terms of financing cost, comparing with the corporate bonds with same rating that pays at rates from 2.5% to 3.2%, the interest rate 2.58% is considerably acceptable. Higher debt levels are leading to higher financial distress costs for the company. However, 20% is still below the industry’s average and appears as a considerable level in order to benefit from advantages that debt provides. The rating of the bond would fall to BBB indicating that the credit risk increases higher debt levels. Although the credit increasing this is still in line with the average.
According to Exhibit 3 the bond This is rating drops to B. This seems rather due to high and risky and would raise the risk is concern of the management and market especially the equity holders, which are described as risk averse. Too much debt-to-capital ratio can cause severe financial distress cost to the company (details to be discussed in section 3). The 4.52 ICR indicates that the debt level is rather risky, as a significant amount of the cash flow generated by the company would be tightened up by a higher repurchase premium and a higher risk premium.
Financial Distress Cost
Higher financial distress cost as the company is entitled to debt obligation where debt holders have the ability to file bankruptcy toward the company. An ICR 11.82 is in line with the industry average and much higher than the bonds with the similar rating (4.1). But as the amount of stock being repurchased rises, the premium required would also increase, resulting in more cash outflow.
In terms of financial flexibility, a relatively high interest coverage ratio (ICR) of 36.8 supports the company’s ability to Flexibility take on more debt. Especially by comparing the ratio with its peers, such ratio seems to match with its risk aversion philosophy. Agency Cost of Debt
Increase in debt-to-capital ratio can cause agency cost of Agency cost of debt will be more problematic This level will involve highest agency debt to be higher. However, at level of 20%, it is still because the managers are not left with freedom cost of debt. considerably low. to operate the company.
Agency Cost of Equity
Adding more debt into capital structure will reduce agency As more debts are added, agency cost of debt cost of equity as managers are left with less free cash flow Lowest agency cost of equity. would be further reduced. that could have been exploited for perk consumption. Since part of the earnings is paid to meet the debt repayments, dividends paid deceases comparing with actual 2011. But this is counter-balanced by increased earnings per share (EPS) as the shares outstanding is reduced Comparing with 20% leverage, dividend continues to decrease but EPS goes up on the scale of EPS in actual 2011, which is favourable for valuation and is in the interest of shareholders.
Dividend paid and EPS decline at the same time, which would lead to a lower valuation of the firm.
1.3 How much value could Hill County create for its shareholders at each of the three alternative debt levels? In order to answer the question we use the change in return of equity (ROE) as an appropriate measure. For the sake of simplicity we used the book value of equity rather than market values. According to Exhibit 4 and 5, the profit margin, total capital and tax rate remain unchanged over the forecasting period. Judging from the table below, the ROE increases when the leverage ratio rises. This is indicating that the more aggressive the capital structure is, the more the extent to which the value is maximized. However, we should take into account the benefit and risk involved when deciding which capital structure is optimal. Alternative 20 % Debt to Capital By implementing 20% of debt into the capital structure the company is able to increase the ROE by over 30% to 16.31%. 40% Debt to Capital An increase to 40% debt to capital is leading to an increase of over 60% in the ROE to 20.52%, which is a positive indicator of increased shareholder value. 60% Debt to Capital
In the third alternative the ROE can be more than doubled to a ROE of 27.64%.
2. What debt-to-capital structure would you recommend as optimal for Hill County? What are the advantages of adding debt to the capital structure? How would issuing debt impact the company’s taxes and expected costs of financial distress? How would the financial markets react if the company increased its financial leverage? In order to determine the optimal capital structure for Hill County Snack, we examined the debt-to-equity ratios for A-rated companies within the food and beverages industry. Based on figure 15.13 in Financial Theory and Corporate Policy by Copeland, we see that the median is 65% debt-to-equity, which in debt-to-capital term equals 40%. We can also see from the figure that none of the firms within the industry operates with zero debt-level, and this gives us an indication that the firm is likely to gain firm value by introducing debt to its capital structure, mainly due to the tax shield of debt. Referring to Modigliani-Miller proposition I (MM I) with taxes, we know that the value of levered firm is equal to value of unlevered firm plus Figur 15.13
tax shield of debt. Also, according to Tread-off Theory, the firm will increase its value by adding debt up to the level where the marginal cost of financial distress is equal to the marginal gain from the tax shield. We used the ICR to evaluate the likelihood of financial distress when the firm introduces debt to the company. The financial market is likely to have a positive reaction if the company increased its financial leverage, since it will increase firm value and ROE, making the company more attractive to investors and other stakeholders. To what extent the stock price will appreciate depends on the market expectations of how the firm will cope with its debt obligations. From Exhibit 4 we see that the firm can easily adopt the 20 % debt-to-capital ratio, having a very high ICR of 36.90 which implies very low probability of financial distress as well as it will be in shareholders’ interest since it increases ROE from 12.5% to 16.31% without adding much risk and reduces free cash flow and agency cost of equity.
Having a closer look on the next scenario where the company is tested with a 40% debt-tocapital ratio, we can see that ROE increases from 12.5% to 20.5%. With this capital structure, the firm operates with the same level as the industry median of its competitors. Implied by Pecking Order Theory, since this is the median, it might indicate that this is somehow the optimal debt structure for this type of industry. The firm will still be very liquid with a relative low probability of financial distress based on the high ICR of 11.82. Finally, we have to consider the 60% debt-to-capital ratio, which results in an ICR of 4.52. This ratio is, just above the median for BBB rated companies by Standard & Poor’s (Exhibit 3). Although the ROE increases form 12.5% to 26.2%, it introduces a significant amount of risk to the company and the firm would be much more sensitive to macroeconomic conditions and fluctuations in revenue.
Based on the three alternatives, we believe that the optimal debt-tocapital structure is around 40%. This is because the company will have a significant benefit from the tax shield of debt and it will cause a large increase in ROE for the shareholders such that they are able to compensat for the increase in risk, reduc agency cost of equity and still be very liquid to fulfil their debt obligation, by having a very high ICR of 11.82, which is even above the median for A-rated companies. The reason we chose this alternative instead of 20% is because we believe that the company can increase its firm value even more with this alternative, without adding a significant amount of risk. Also, if the company were to introduce 60% debt-to-capital, we think this is a too aggressive approach for the company that is new to debt in its capital structure. 3.
How could Hill County implement a more aggressive capital structure? What methods could be used to increase debt and decrease equity? A more aggressive capital structure would in general mean that the company is increasing the leverage ratio by either increasing the debt or reducing the equity or both. The main two reasons why companies look to reduce the share capital and make capital distributions to shareholders (i.e. return cash surplus to shareholders in excess of the immediate
requirements of the company) are: a) enhancing shareholders’ value though an improved ROE; and b)to achieve a more efficient capital structure. The following are possible approaches that Hill County can undertake to adopt a more aggressive capital structure. 1) Implement Debt Financing Debt financing refers to any borrowed money which Hill County would have to pay back to the lending institution. It can come in the form of a loan, line of credit, bond, etc. We would highly recommend Hill County to seek capital by issuing bonds rather than having bank loans. In our view, Hill County can benefit more from bonds issued than from a bank loan. The interest rate and other terms of bank loans are set by the bank, whereas when issuing bond, it can actively set the interest rate and schedule the payments based on the current market conditions. Even though it would be its first issue of bonds, we see the risk involved and cost incurred rather minor, due to the relative strong financial reports of the company, assuming the market is efficient.
Although most companies, including Hill County, can borrow from banks, they view direct borrowing from a bank as more restrictive and expensive than selling debt to the open market. In order to maintain the degree of flexibility that is offered by all equity financing, the CEO would try to avoid any restrictions that come with debt financing. Most bank loans come with multiple conditions, or covenants, that the borrower must follow for the life of the loan. Bank loan covenants protect the bank (and in effect bank loan fund investors) but impose restrictions on the borrower. As the advantages outweigh the disadvantages we recommend Hill County to seek for bond financing rather than a bank loan. 2) Reduction of Equity Alongside the debt financing via bonds, we suggest that Hill County should reduce their share capital.. A reduction of equity is used to increase distributable reserves to make dividend payments possible, or to make a large return of capital more efficient. There are a number of possible mechanisms, including: A share buyback, where Hill County buys its own shares back in the market.
These shares are usually then cancelled. Companies do sometimes retain bought-back shares as treasury shares in order to be able to re-sell them, or allocate them to fulfil share options or to otherwise avoid issuing new shares. In the case of Hill County, we would advise them to cancel the shares as we are seeking for a possibility to reduce the equity share capital. Another alternative for County Hill is the conversion of share capital and nondistributable reserves into debt capital. This approach has been used by large UK listed companies, and is basically the conversion of share capital into debt. Existing shares are cancelled and replaced with new shares (fewer, or with a lower par value) and bonds, the latter typically redeemable at the option of the holder. This allows shareholders to take the return of capital as a capital gain, and time it to their advantage. One easy solution would be the conversion of non-distributable reserves into distributable reserves, which is followed by the payment of a special dividend. This, however, would mean that many shareholders would be unable to avoid paying income tax on the special dividend.
3) Hybrid Securities In addition to financing either by debt or by equity, such hybrid securities as convertible bonds can both alter the capital structure and provide the management with flexibility. Within a certain time period or when the share price is low, the convertible bonds would contribute to the total debt amount, which requires fixed and rather low periodic payment. Hence, the leverage ratio would rise. However, as time goes by or when Hill County’s stock price appreciates, these bond holders may convert the bond and thereby such amount would switch into equity. 4) Off Balance Sheet Financing (OBF) Apart from general debt financing we would also consider the implementation of off balance sheet financing. As the leverage ratio goes up and increase the riskiness of the company, the CEO and share holders may concern such would weaken the strength of balance sheet and periodic performance. But certain OBF methods like leasing and factoring can enhance the cash flow of the firm and substantially build up the leverage without adding to the amount of the debt.
4. Considering Hill County’s corporate culture, what arguments could you use to persuade CEO Keener or his successor to adopt and implement your recommendation? Considering the management focus of Hill County is to maximize shareholders’ wealth, raising the leverage ratio of the firm can help the management to achieve such goal. First of all, using the issued debt to repurchase stock can not only push up the stock price but also bring shareholders tax benefit, which supports equity holders in managing their wealth more efficiently. Also, in line with our previous discussion, introducing debt into the firm’s capital facilitates managers to take up slightly more risky but also more profitable investment opportunities. This is because leverage can reduce the risk that is bore by equity, instead of missing out potentially profitable projects so as to maintain sufficient cash flow.
Regarding the company’s strong commitment to efficiency and cost control, issuing debt can provide the company with considerable tax shield as interest payment is tax-deductible. Thus, reducing tax payments can lower expenses and retain more economic benefit within the company. Another advantage is that leverage can lower the weighted average cost of capital since the cost of debt is usually lower than the cost of equity, which contributes to its cost control policy. In such way, Hill County can more efficiently (lower cost of capital) and sufficiently (higher level of retained earnings) finance its daily operations and other investment projects. A third aspect of the Hill County’s corporate culture is caution and risk aversion, meaning that the managers always prefer financial safety and flexibility. Introducing debt into the capital structure of the company can stabilize the cash outflow as the company can schedule whichever principle and interest payment that is suitable to the operating and financing requirements and thereby enable the management to control risk exposure.
Also, Hill County can issue debt with embedded options such as callable bonds, enabling the firm to buying back the bonds at a certain price when debt-financing is unfavourable. Lastly, if the management is still concerned about rising debt levels would lead to weaker financial reports, other capital sources such as off-balance sheet financing can change the capital structure without much dynamic and unfavourable change of the crucial financial ratios, say, debt-to-equity ratio and interest coverage ratio, which have a strong impact onto the evaluation of Hill County’s risk level.