Hill Country’s operating strategy and its impact on business risk & financial strategy The operating strategy is to produce high quality products through efficient, low-cost and aggressive operation as well as singular management. In detail, the company provides several kinds of snacks to satisfy different type’s customers. The company expands its presence into sporting events, movie theaters and other leisure events to attract customers. An efficient and low-cost operation is achieved by strong control of budgets and costs. Customers are satisfied by companies’ quick react to their requirements or preferences and reinvent and expand its products, showing the efficient management for the customer requirement.
Also, all decisions are made in order to build shareholders’ value, indicating singular management. For the business risk, the snack foods industry was very competitive, facing off against competitors like PepsiCo and Snyder’s-Lance very day. In this high rivalry industry, company could not succeed by price increase. And unfavourable cost due to both internal and external factors is not easy to control. In order to control the business risk, the company is actively involved in the budget approval process, and the operating strategy has very important part to keep the costs under control. For the financial risk, the more debt financed the higher financial risk it is. The company’s risk avoidance strategy is manifested in its financing decision. The company is managed in preference for equity finance and against debt finance, investments are funded internally.
The optimal capital structure for Hill Country
The optimal capital structure is the capital structure at which the market value is maximised and the cost of capital is minimised. There are 3 alternative capital structures from pro forma 2011 financial information. If Hill take 60% debt to capital ratio, the company repurchases the most of the shares comparing with 20% and 40% debt to capital ratio structure, the debt would be B rated with highest interest rate of 7.7%, reflecting the higher risk. The net income would drop to $76M, however, the tax would reduce by around $12M, but the interest expense increases to $33.5M, there is big gap between them. In terms of the 20% debt to capital ratio one, the debt is rated at AAA with 2.85% interest rate, the tax and interest both decreases and increases slightly, the EPS and dividend per share in 20% and 60% are less than which in 40% scenario.
Regarding to the 40% debt to capital structure, the debt is rated at BBB with 4.4% interest rate. Also, the interest coverage ratio is strong(11.8). The very important part is that even the net income reduces by 8.5%, the EPS and dividend per share, are both the highest compared with 20% and 60% scenarios, thus adding value to the shareholders. In addition, it allows the firm not to be over leveraged, which is in favor of the firm that it does not want to have too much debts. The financial risk is the highest in the 60% scenario since the shareholders have the highest financial leverage(facing bankruptcy). According to the calculation(appendix), the highest value of the firm is $2482M under 40% debt scenario compared with 20% and 60% debt scenarios, thus maximizing the firm value. Therefore 40% debt to capital structure is recommended.
Benefits of debt financing
Debt financing allows control of business. Owner can made decision and does not need consider shareholders or investors. * Debt is tax-deductible. This means that it shields part of business income from taxes and lowers the tax liability. * The lender do not share the profits. Business only need to make repayment. * Debt is less expensive than equity due to its contractual nature and priority claim How large the benefits are depending on the magnitude of the tax benefit numbers, the benefits that reallocated to investors and whether the costs of debt that are less than the benefits from debts.
Changes the capital structure?
It is recommended that Hill Country to change the capital structure. The capital structure is too conservative, having negative impact on financial performance measures. Hill Country has excessive liquidity, and the interest rate is quite low, it is good opportunity to involve debts. The impacts of the change would be the increase in debt and decrease in equity. The company can get advantage of debts as mentioned before, it is aggressive growth strategy. And the financial ratios such as ROE, ROA, EPS, dividend per share as well as the value of firm would improve. Also, the repurchase of the shares will result in the increase in the share price.
However, most lenders provide severe penalties for late or missed payments, which may include charging late fees, taking possession of collateral, or calling the loan due early. Failure to make payments on a loan, even temporarily, can adversely affect a small business’s credit rating and its ability to obtain future financing. Debt financing is also borrowing against future earnings. This means that instead of using all future profits to grow the business or to pay owners, the firm has to allocate a portion to debt payments. Also, debt can limit future cash flow and growth, decreasing in equity could lead to higher debt-to-equity ratio.
Alternatives to increase debt/decrease equity
Instead of issuing debt, the firm can borrow debt from banks to increase debt. In order to reduce equity, another method is to rewards its investors by distributing a portion of its profits in the form of cash dividends. Since the cumulative earnings of a company are reported within the balance sheet equity account “retained earnings,” cash dividends are shown on the company’s financial statements as a direct reduction of the account. In addition, Increase expenses can bring the same effect. Depreciation is an operating expense that allows a business to allocate or spread the costs of its assets over the length of their useful life. The use of an accelerated depreciation method results in a higher depreciation expense during the asset’s earlier years of service, resulting in a lower net income and equity balance during this time.
Conclusion and Recommendation
Due to the strong cash balance and high liquidity of the firm, it is recommended that Hill Country to take 40% debt to capital finance with respect to the several benefits with the debt financing to increase the firm value. Also, the firm can consider the alternative ways to change the capital structure.
Hamada equation: Beta L=Beta U[1+(1-T)(D/E)
Risk free rate(Rf)=1.8%
Market interest rate(Rm)=3.8%
cost of equity=Rf+ Beta L*(Rm-Rf)