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10.11.201310.11.2013Case Study: Hill Country Snack Foods Co.
10.11.2013
10.11.2013
Question 4: Considering Hill Country's corporate culture, what arguments could you use to persuade CEO Keener or his successor to adopt and implement your recommendation?
Recap: Hill Country Snack Foods Co. (HC) has been an all equity-financed company with a debt-to-capital ratio of 0%. Its corporate culture is characterized by caution and risk-aversion whereas increasing shareholder value has been one of HC's most important objectives. Following recommendations given in Questions 1 – 3, HC should implement a more aggressive capital structure.
By adapting a more aggressive capital structure, i.e. increasing leverage, HC can take advantage of low interest rates. Seen as Keener (and most probably his successor as well) own shares themselves, an increase in shareholder value has to be a strong argument to convince the CEO. Furthermore, adding debt will give a signal of strength to the market when value goes up since shares become more attractive.
To persuade Keener, one could argue that implementing more debt to HC's capital structure will reduce financing costs and create tax shields (due to interest deduction HC can then benefit from tax savings). Thus, by using debt HC would also be able to reduce the use of equity and increase the profit retention within the company.
Finally, there will be a positive reaction from the markets driven by the fact that the bonds will still be considered safe (BBB rating with 40% D:C) and shareholders will gain benefit from an increase in dividends.
"[…] a firm should increase debt until the value from PV (tax shield) is just offset, […], by increases in PV (costs of financial distress)"1, i.e. that there is an optimal point of how much money a firm should borrow.
With the already presented advantages one could be able to convince the CEO of a new capital structure. But one should not exaggerate with borrowing too much debt, i.e. one should be aware of not exceeding the optimal debt ratio which would be at highest 40% (as shown in the question 2). Otherwise the interest expenses increase, and thus would lead to decreased EPS. Since exceeding the optimal debt ratio can lead to financial distress, the stock price would decrease.
In conclusion we can say that taking debt is always advantageous until reaching the optimal debt ratio.
