Hill Country Foods free essay sample

Country Snack Foods is a company which produce variety of snacks. Their operating strategy is a combination of good products, efficient and low-cost operation, and singular management. * Good products are not only about high quality, but also about to satisfy different type’s customers by producing many kinds of snacks. Customers are satisfied by companies’ quick react to their requirements or preferences and reinvent and expand its products. For example, the company has also tried to change the recipe to meet students’ nutrition requirements. An efficient and low-cost operation is achieved by strong control of budgets and costs. Then, operating and capital budget can be lean and aggressive. * A singular management is as simple as all decisions were made to build shareholders’ value. For the business risk, market is shared by competitors like PepsiCo and Snyder’s-Lance. 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. For the financial risk, the more debt financed the higher financial risk it is. In this case, the company operating strategy allowed it to increase market share by good products and decrease the cost and sustain competitive price by efficient and low-cost operation. In order to have more control power of the company and decrease the risk, the company only extend existing products and acquire smaller specialty companies and all funds are equity financed with no debts. Hence, has no financial risk and interest cost. However, it is questionable that does this zero debt capital structure really maximize the shareholders’ value. Think about what benefits company can get from debts. The implications of Miller and Modigliani’s (1963) proposition 3 suggested that, in the world with tax, company could benefit from gearing-up. The higher the leverage the more tax relief it obtains and the smaller its tax liability becomes. There would also have a lowered after tax WACC. Weighted average cost of capital (WACC) is a calculation of a firms cost of capital in which each category of capital is proportionately weighted. And the value of firm=Present Value of (after Tax) Cash Flow to Firm, discounted back at WACC. If cash flows to firms are held constant, and cost of capital is minimized, value of firm will be maximised. Thus, as debt increases, the WACC will decrease, and the value of firm increases. Furthermore, debt financing can add discipline to management. In contrast to equity financing, the entrepreneurs are able to make key strategic decisions and also to keep and reinvest more company profit. According to the long-term bonds interest rate in early 2012, market yield on 10-year bonds were under 2%, and a public traded 10-yrs bonds issued by â€Å"A† rated corporations were trading at 3. % yield to maturity, that means debt financing was much cheaper than equity financing as Hill Country’s dividends payout ratio is almost 30%. (In Exhibits 3) In exhibit 2, financial information is compared between Hill Country and its competitors. The Giant, PepsiCo had a debt-to-capital ratio of 49. 6%, though its ROA is a bit lower than Hill Country’s, its ROE of 30. 8% is much h igher than 12. 5%. this may demonstrate that the raise of debt can increase return of equity. So, which capital structure is more optimal for Hill Country in Exhibit 4. We need to calculate the WACC for each capital structures. Weighted average cost of capital (WACC) is a calculation of a firms cost of capital in which each category of capital is proportionately weighted. See the figure 1 below. Firstly, we need to find cost of debt and cost of equity. The cost of debt can be find in exhibit 5. On this basis, the most commonly accepted method for calculating cost of equity comes from the capital asset pricing model (CAPM): The cost of equity is expressed formulaically below: Re = rf + (rm – rf) * ? Where: †¢Re = the required rate of return on equity †¢rf = the risk free rate †¢rm – rf = the market risk premium †¢? beta coefficient = unsystematic risk The risk free rate can be set as 10-yrs treasury bond rate, which is 1. 8%. And market return is set up to be 10%. Beta changes as the debt ratio changes. See the figure 2 below Beta unlevered =1, and Batas levered are calculated in the excel. And we can get cost of equity by CAPM to calculate WACC. Then, the firm value can als o be calculated. We assume the growth rate of FCF is 8. 2% which is the annual growth rate of sales in 2011. From the table above, we can see that with 20% debt to capital ratio, the company will have the lowest WACC 9. 7% and highest firm value of $9894. 338. Therefore, a 40% of debt should recommend to Hill Country’s capital structure. After the restructure of capital structure, the business risk will increase because the bankruptcy risk will rise long with debt. The two problems from agency theory will come to front, since the decisions are not solely made by shareholder, the control has been diluted. There will be much less dividends payment, and the retained earning can be used for expansion and future growth. More benefits can get from debt financing is that if the corporate bonds are public traded, the company will be rated. In this way, investors will increase confidence if the rate is high which may push the share price up and increase the market value of firm. Other things like tax and expected cost of financial distress affect by debts can be explained in the bellowing graph The graph shows that the value of the firm as a whole can be increased by using higher levels of borrowings, up to a point where the benefits of gearing are offset by the disadvantages of financial distress. Overall, the company and shareholder are all benefited from debts finance which can build up an optimal capital structure with lowest WACC.