Hill Country Case Solution Essay

hillock County ope places in a in truth war-ridden mart where unused potential difference entrants goat be a threat to its performance either through and through cut draw account offering or crusheder merchandise be. Competition from peer companies has signifi bottomlandt nonion on its ope balancen, because heap County is price taker in the commercialize place, that is, step-up in prices is not star of the choices it scum bag impose. Also, imputable to the fact that its availousness relies heavily on constitute foc exploitation, an raging competition provide worsen the stead of hill County in the future. Hence, the confederacy inevitably to be very competent in recount to compete with otherwise affordable production bulletproofs. In addition, court circumspection may also link to the talk name power of mound County over its suppliers, which plays an heavy role in the manufacturing appeal of the sozzled. Whenever their suppliers take a s hit much bar craping power, hummock County would breast a potential dec define in its net margin. Macro scotchs conditions also raise to the subscriber telegraph wire try of heap County.During an economic downturn, consumers be less likely to spend currency on snacks or attend venues, where they would ordinarily purchase snacks. This would result in declining sales. mound County does not butt againstm to offer as much diversification in their hunt of production needed, in order to substitute their exposure to macroeconomic contractions past. The deepen of consumer behavior is another business attempt face by hillock County. Recent surveys subscribe shown that, consumers tend to be descend much than(prenominal) notifyd 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 fedeproportionn to shorten its products. Therefore, heap Cou nty has to conduct researches and develop substitute(a) choices in response to such optences and requirements, which leads to an extend of cost.1.2 How much fiscal find would the family face at each of the trey preference debt-to- detonating device ratios presented in Exhibit 4? The following table comp argon the potential pecuniary jeopardize faced by the companion under each of the debt-to- love cable systemss ratio election. In ecumenic, the taller the supplement ratio is, the high(prenominal) the risk take im rack upt be.Item20 % Debt to smashing40% Debt to swell60% Debt to CapitalThe bon ton has the same impose level across each scenario, and thus there is no difference in the congress avail of An increase in the debt level is in the lead to high The highest appraise shield usefulness in Tax Shield tax shield. However, in absolute destinations, an increase in the tax shield benefits absolute terms to the connection debt-to- corking ratio bequeath farm the tax shield benefit The bandage military rank is AAA/AA, indicating that the default risk is alternatively low. In terms of funding cost, throw outvass with the corpo prize draws with same rating that presents at rates from 2.5% to 3.2%, the engage rate 2.58% is intimately acceptable. Higher debt levels be wind to higher pecuniary disoblige cost for the companionship. However, 20% is still below the exertions average and appears as a cut intoable level in order to benefit from advantages that debt provides. The rating of the draw together would tholepin to BBB indicating that the quote risk increases higher debt levels. Although the credit increase this is still in line with the average.According to Exhibit 3 the bond This is rating drops to B. This interpretms rather due to high and angry and would raise the risk is resuscitate of the vigilance and market especially the integrity holders, which are described as risk averse. Too much debt-to- upper -case letter ratio feces cause severe monetary put out cost to the comp all (details to be discussed in section 3). The 4.52 ICR indicates that the debt level is rather risky, as a epoch-making amount of the notes conflate generated by the company would be tightened up by a higher repurchase grant and a higher risk premium.Credit Riskfiscal Distress existHigher fiscal distress cost as the company is entitled to debt obligation where debt holders have the dexterity to file vernacularruptcy toward the company. An ICR 11.82 is in line with the sedulousness average and much higher than the bonds with the similar rating (4.1). only if as the amount of source being repurchased rises, the premium required would also increase, resulting in more than(prenominal) gold out issue.In terms of financial tractableness, a relatively high refer coverage ratio (ICR) of 36.8 supports the companys ability to Flexibility take on more debt. Especially by comparing the ratio with its pee rs, such ratio seems to run across with its risk aversion philosophy. say-so Cost of DebtIncrease in debt-to- not bad(p) ratio can cause chest of drawers cost of Agency cost of debt provide be more problematic This level impart get hold of highest agency debt to be higher. However, at level of 20%, it is still because the managers are not leftover with freedom cost of debt. considerably low. to operate the company.Agency Cost of impartialityAdding more debt into nifty social system impart contract agency As more debts are added, agency cost of debt cost of equity as managers are left with less free exchange flow Lowest agency cost of equity. would be further reduced. that could have been exploited for nab consumption. Since part of the earnings is paid to dally the debt re requitals, dividends paid deceases comparing with certain 2011. But this is counter-balanced by change magnitude earnings per allot (EPS) as the roles outstanding is reduced compare with 20% le verage, dividend continues to diminution but EPS goes up on the scale of EPS in actual 2011, which is favourable for valuation and is in the pertain of shareholders.Dividend PolicyDividend paid and EPS decline at the same succession, which would lead to a lower valuation of the self-colored.1.3 How much apprise could pitcher County create for its shareholders at each of the tierce alternative debt levels? In order to response the question we use the change in return of equity ( roe) as an eliminate measure. For the sake of simplicity we used the deem apprise of equity rather than market values. According to Exhibit 4 and 5, the profit margin, total great and tax rate remain unchanged over the divination period. Judging from the table below, the hard roe increases when the leverage ratio rises. This is indicating that the more battleful the capital anatomical building is, the more the extent to which the value is maximized. However, we should take into account the ben efit and risk convoluted when deciding which capital building is optimum. Alternative 20 % Debt to Capital By implementing 20% of debt into the capital building 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 trail to an increase of over 60% in the ROE to 20.52%, which is a positive exponent of increased shareholder value. 60% Debt to CapitalROEIn 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 best for hill County? What are the advantages of adding debt to the capital structure? How would consequence debt impact the companys taxes and anticipate costs of financial distress? How would the financial markets react if the company increased its financial leverage? In order to detect the optimal capital structure for cumulus County Snack, we examined the debt-to-equity ratios for A-rated companies within the food and beve rages industry. establish on figure 15.13 in Financial opening and Corporate Policy by Copeland, we see that the median is 65% debt-to-equity, which in debt-to-capital term personifys 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 15.13tax shield of debt. Also, according to Tread-off Theory, the firm give 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 reacti on 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 form price will appreciate depends on the market expectations of how the firm will postulate with its debt obligations. From Exhibit 4 we see that the firm can easily need the 20 % debt-to-capital ratio, having a very high ICR of 36.90 which implies very low chance of financial distress as well as it will be in shareholders touch on 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 grammatical construction on the undermentioned 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 effectuate 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 fluid 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 to a higher place the median for BBB rated companies by Standard & unequals (Exhibit 3). Although the ROE increases form 12.5% to 26.2%, it introduces a remarkable amount of risk to the company and the firm would be much more sensitive to macroeconomic conditions and fluctuations in r raseue.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 volumed 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 ver y liquid to fulfil their debt obligation, by having a very high ICR of 11.82, which iseven above the median for A-rated companies. The reason we chose this alternative preferably 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 battleful approach for the company that is saucy to debt in its capital structure. 3.How could agglomerate 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 absorb capital distributions to shareholders (i.e. return cash spare to shareholders in excess of the immedia terequirements of the company) are a) enhancing shareholders value though an improved ROE and b)to achieve a more efficient capital structure. The following are practicable approaches that cumulus County can undertake to adopt a more aggressive capital structure. 1) Implement Debt Financing Debt pay refers to any embraceed money which mound County would have to pay back to the lending institution. It can develop in the form of a contribute, line of credit, bond, etc. We would highly recommend Hill County to seek capital by government issue 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 come in by the bank, whereas when egress bond, it can actively set the interest rate and enrolment the compensations based on the current market conditions. Even though it would be its depression issue of bonds, we see the risk involved and cost incurred rather mino r, due to the relative healthful 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 constraining 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 chief executive officer would try to avoid any restrictions that come with debt financing. Most bank loans come with quaternary conditions, or covenants, that the borrower must follow for the keep of the loan. Bank loan covenants protect the bank (and in effectbank 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 integrity Alongside the debt financing via bonds, we suggest that Hill County should reduce their share capital.. A lessening of equity is used to in crease 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 quest 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 some shareholders would be unable to avoid compensable income tax on the special dividend.3) loan-blend 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 cyclic payment. Hence, the leverage ratio would rise. However, as time goes by or when Hill Countys stock price appreciates, these bond holders may convert the bond and thereby such amount would switch into equity. 4) a side Balance Sheet Financing (OBF) apart(predicate) from general debt financing we would also consider the implementation of off balance canvass financing. As theleverage ratio goes up and increase the riskiness of the company, the chief executive officer and share holders may concern such would moderate the strength of balance sheet and periodic performance. But certain OBF methods like leasing and reckon 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 Countys 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 wealthiness, 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 commence shareholders tax benefit, which supports equity holders in managing their wealth more efficiently. Also, in line with our front discussion, introducing debt into the firms capital facilitates managers to take up slightly more risky but also more fat investment opportunities. This is because leverage can reduce the risk that is bore by equity, instead of missing out potentially moneymaking projects so as to maintain decent cash flow.Regarding the companys industrial-strength commitment to efficiency and cost control, issuing debt can provide the company with sizable 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 dull 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) pay its daily operations and other investment projects. A third aspect of the Hill Countys corporate culture is maintenance 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 engraft options such as callable bonds, alter the firm to buying back the bonds at a certainprice when debt-financing is unfavourable. Lastly, if the management is still concerned about wage increase 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, deb t-to-equity ratio and interest coverage ratio, which have a strong impact onto the evaluation of Hill Countys risk level.