10.11.

2013

Case Study: Hill Country Snack Foods Co.

Question 4: Considering Hill Countrys 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 HCs
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 HCs 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.

References
1.

Brealey, Myers, Allen: Principles of Corporate Finance

(10th Edition): p. 379, 1: 466 - 468, 484 - 490

2.

28C00100_lectures_whole_package_2013

3.

http://highered.mcgraw-hill.com/sites/0072467665/stud
ent_view0/chapter18/

4.

http://campus.murraystate.edu/academic/faculty/lguin/F
IN330/Optimal%20Capital%20Structure.htm

5.

http://www.investopedia.com/exam-guide/cfa-level1/corporate-finance/debt-effects-capital-structure.asp