MGMT6021 Assignment - Hill Country Snack Foods PDF

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Hill Country Snack Foods...

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Corporate Finance for Managers (MGMT6021) Assignment 2: Group Project Trimester 3 - 2018

HILL COUNTRY SNACK FOODS CO

10 Pages (excluding cover page, table of contents, references and appendices)

Table of Contents 1.0

Question 1

4

2.0

Question 2

7

3.0

Question 3

10

4.0

Question 4

11

5.0

Question 5

12

6.0

References

14

7.0

Appendices

15

7.1.

Appendix 1 – Financial Statements and Ratio Analysis

15

7.2.

Appendix 2 – Strengths, Weaknesses, Opportunities and Threats Analysis

18

7.3.

Appendix 3 – DEBT Ratio analysis

19

7.4.

Appendix 4 – 20% DEBT Ratio Sensitivity analysis

20

7.5.

Appendix 5 – 40% DEBT Ratio Sensitivity analysis

21

7.6.

Appendix 6 – 60% DEBT Ratio Sensitivity analysis

22

7.7.

Appendix 7 – Free Cashflow

23

7.8.

Appendix 8 – Additional Graphs

24

MGMT6021 Corporate Finance for Managers – Trimester 3, 2018 - Assignment 2 Group Members: Botha, Calder, Drennan, Lamattina

Page 2 of 27

1.0 Question 1 The corporate culture of Hill Country Snack Foods (HCSF) was driven by decisions which built shareholder value. This focus came from the CEO Howard Keneer over the last 15 years and, given that he and other managers held approximately 17% of the outstanding shares in the company, this was personally beneficial to the management team. HCSF’s managerial philosophy was one of caution and risk aversion which included its financial strategy in accessing funding through equity as opposed to debt with growth being incremental as can be seen in its sustainable growth rate at an average of 7.7% over the last 6 years. (Appendix 1) Table 1:

Hill Country Snack Foods Company

Key Performance Ratios

Snyder Lance 2011

Pepsi Co 2011

2006

2007

2008

2009

2010

2011

Annual growth rate of sales

n/a

3.2%

3.7%

7.4%

6.9%

8.2%

17.5%

13.6%

Annual growth rate of E.P.S.

n/a

-18.3%

1.9%

26.4%

17.4%

22.0%

-0.4%

3.6%

Internal Growth Rate (IGR)

9.3%

6.6%

6.4%

7.3%

7.9%

8.8%

-0.6%

15.6%

Debt Ratio

20.8%

22.0%

21.3%

20.6%

20.5%

20.4%

25.2%

43.1%

Leverage Ratio

1.2620

1.2818

1.2707

1.2602

1.2585

1.2561

1.7491

3.4873

Current Ratio

2.01

0.73

0.47

Quick Ratio

1.54

0.44

0.35

90.6%

5.6%

12.9%

Cash Ratio

77.9%

67.3%

64.8%

82.1%

89.7%

The combination of good products and efficient, low cost operations produced consistently strong financial results which are underlined by the company’s high level of liquidity given its high current and quick ratios and strong Internal Growth Rate (IGR) as can be seen in Table 1. This trails that of Pepsi Co, a substantially larger company, but can be attributed also to the absence of debt on the balance sheet of HCSF. Conversely, Snyder Lance, despite its high sales growth rate, is operating an unsustainable business which is experiencing negative growth as can be seen in Figure 1. HCSF’s conservative capital

ROE, ROC, ROA & IGR Comparison $7,000

$6,443.0

30%

1

$5,000

25%

consistent

20% 15%

$3,000

10%

$2,000 $1,000

5%

$97.6

$38.3

$0

C SF C 1 H 01 2

0%

's er d ny

Net Income Return on Equity (ROE) S Return on Assests (RO A)

11 20

-5%

ROE, ROC, ROA, IGR

$6,000

$4,000

Net Income

structure as shown in Appendix

35%

11 20 o iC Sustainable Growth Rate (IGR) ps e P Return on Capital (ROC)

Figure 1: Industry Financial Comparison

indicates

that

strong

despite financial

performance in ROA and ROE, its ratios generally, trail that of leveraged companies such as Pepsi.

Mature

managed

and

well

companies,

like

Pepsi Co typically highlight the differences

in

performance

driven by diverse capital

MGMT6021 Corporate Finance for Managers – Trimester 3, 2018 - Assignment 2 Group Members: Botha, Calder, Drennan, Lamattina

Page 3 of 27

Source: Constructed from data in Exhibits 1 & 2

structures. The industry in which these companies operate, like Campbell Soup, typically have a low beta (Brealey, Myers and Marcus 2017, 376) within the US market indicating that they operate an inherently low risk business. With HCSF, the absence of debt finance and the presence of large cash holdings, as identified in the Strengths, Weaknesses, Oppertunities and Threats (SWOT) analysis in Appendix 2, has been a strength in the past as it dealt with the economic downturn between 2007 & 2009. However, in the current market it represents a threat to the business. As the company continues to grow, currently at a sustainable growth rate of 8.8%, this sustained business success increases the likelihood of the realization of a takeover threat hence increasing overall business risk. Consistent with the management philosophy of increasing shareholder value, HCSF can introduce debt into its capital structure as a means of delivering improved shareholder outcomes, but in doing so they need to identify the optimal capital structure.

Figure 2 below illustrates the

movement in earnings per share (EPS), dividends per share (DPS), net profit margin (NPM), return on assets (ROA) and return on equity (ROE) at five different debt ratios. As illustrated in Figure 2, HCSFs’ EPS and DPS are maximized at around 40% debt ratios, which will contribute to an increase in shareholder value. Whilst the NPM decreases relative to interest burden, their ROE increases with $3.50

$3.19

$3.25

$3.24

$3.11

Rate of Return %

$3.00 $2.88

30% 25%

the

reduction

in

the

weighted average cost of

$2.50

20%

$2.00

$0.85

$0.96

$0.98

9

$0.97

$0.93

$0.50 $0.00 Actual Earnings per share Return on assets

20% 30% 40% 50% Dividends per share Debt Ratio Return on equity (Book Value)

capital (WACC) as cost of

15%

debt is lower than the cost

10%

of equity. The inherent

5%

financial

$1.50 $1.00

higher debt ratios, due to

0% 60% Net profit margin IGR

Figure 2: HCSF Company Returns

risk

with

an

increase in the debt ratio results in a reduced debt rating,

and

increased

interest premium.

Source: Constructed from data in Exhibits 4

The higher the debt ratio, the higher the likelihood of financial distress. Currently, Pepsi Co is operating at interest coverage of 11.25 and Snyders’ are operating at an interest coverage of 6.67 as illustrated in Figure 4 below. Given the high level of profitability of HCSF, adopting debt at levels up to 40% does not place excessive financial pressure on the company as their interest coverage ratio is generally higher than their industry peers, as illustrated below in Figure 4. This is reflected in the debt rating of HCSF at 40% being BBB and at 20% being AAA/AA as illustrated in Appendix 3.

MGMT6021 Corporate Finance for Managers – Trimester 3, 2018 - Assignment 2 Group Members: Botha, Calder, Drennan, Lamattina

Page 4 of 27

Interest Coverage Times Multple

50 45 40 35 30 25 20 15 10 5 0

The

sensitivity

indicates

analysis

a

downgrade

potential

of

HCSF’s

respective bond will

0

0

Snyder’s

0

0

110%

100%

until

it

current EBIT. 0

0

90%

0

0

0

80%

Change in EBIT HCSF 20% HCSF 40%

Pepsi

occur

reaches less than 30% of

11.25 6.67

120%

not

ratings

0

30%

HCSF 60%

Figure 4: Interest coverage ratios for varying EBIT and Debt ratios. Source: Constructed from data in Exhibits 4

Figures 5 and 6 below illustrate how the EPS and P/E is impacted through the movement in EBIT whilst the debt ratio adopted does not materially impact these results. This is consistent with MM’s Proposition Iwhere the value of the firm is unaffected by its capital structure and the firm’s debt policy is irrelevant to shareholders (Brealey, Myers and Marcus 2017, 472). The benefit to EPS and P/E is driven by the income tax shield on the interest payments which increases as debt ratio increases. The benefits of higher debt ratios diminish after a certain point due to the increased interest/coupon rates associated with diminishing credit ratings. 40

4.08 4

Price Earnings Rato

Earnings Per Shae ($)

5

3 2 1 0

0.57 120%; 120% 0110%; 110%0 100% 90%; 90% 0 80%; 80% 0

Snyder’s HCSF 40%

Pepsi in EBIT Change

HCSF 20%

HCSF 60%

Figure 5: EPS sensitivity analysis based on EBIT change Source: Constructed from data in Exhibits 4

30 20 10 0 120% Snyder’s HCSF 40%

110%

100%

Pepsi in EBIT Change

90%

80%

HCSF 20%

HCSF 60%

Figure 6: Price Earnings sensitivity analysis based on EBIT change Source: Constructed from data in Exhibits 4

Based on a cash flow forecast of five years using the current growth rate of the company and a 70% retention rate of earnings, HCSF can reverse the decision to adopt debt of $145,000 (20%) within one year, debt of $290,000 (40%) could be reversed within four years, whilst debt of $435,000 (60%) would require more than 5 years. Table 2 illustrates the projected cash at bank balances at the end of each year until 2015 based on the assumption that the company can choose to accumulate retained earnings in cash. In undertaking a share valuation analysis at each debt ratio, we adopted the dividend discount model and applied a growth rate based on the average growth rate experienced between Pepsi, Snyder’s-Lance and HCSF. This demonstrated

MGMT6021 Corporate Finance for Managers – Trimester 3, 2018 - Assignment 2 Group Members: Botha, Calder, Drennan, Lamattina

Page 5 of 27

that through the share Table 2: Projected cash balances

Loan Amounts 2011 2012 2013 2014 2015

20% $145,000

Debt Ratio 40% $290,000

$126.10 $195.98 $269.44 $346.67 $427.85

$126.10 $142.05 $211.58 $284.88 $362.14

repurchase program, the company 60% $435,00 0 $126.10 $132.70 $192.89 $256.85 $324.75

was

repurchasing

shares

at

a

discount to the effective value of the company at each increment of debt. The largest discount was experienced at around a 40% debt level, where the price earnings multiple was also at its lowest

In conclusion, by adopting debt within the capital structure up to a 40% debt ratio, the financial risk is considered relatively low given the consistently strong financial performance of HCSF. Debt ratios in excess of 40% bring the likelihood of financial distress closer as can be illustrated within the interest coverage analysis and the shareholder value reviews above. 15.00

50.00

14.50 14.00

Share Price

40.00

13.50

30.00

13.00 20.00

12.50

10.00 0.00 Actual

12.00 20%

Share Price Valuaton

30%

40%

50%

Debt Ratio Share Value/Repurchase Price

However,

debt

ratios

lower than 30% fail to Dividend Per Share

60.00

11.50 60%

optimize the value to the shareholders. As such, the

optimal

capital

structure for HCSF is with

a

debt

ratio

between 30% and 40%.

P/E rato

Figure 7: HCSF Shareholder Value Analysis at various debt ratios. Source: Constructed from data in Exhibits 4

2.0 Question 2 Adding debt to the capital structure has an impact on EPS, NPM, ROA and ROE as illustrated in Figure 2 above with an organization’s goal being identification of an optimal capital structure where debt contributes to shareholder value. The IGR of the company, which is the maximum rate of growth without external financing (Brealey, Myers and Marcus 2017, 540), is also affected by adding debt to the capital structure as illustrated in Appendix 3. Currently HCSFs, IGR is 8.82% without financing. Comparative industry analysis against Pepsi Co, which has an IGR of 15.56% with debt ratio of 49.5% and Snyder’s-Lance which has an IGR of -0.4 with a debt ratio of 23.5%, demonstrates the impact of debt on a company’s IGR. Increasing debt results in an increase in IGR however, Snyder’s-Lance’s negative IGR, which is not sustainable, can be attributed to high operating costs as they have a low EBIT for their volume of sales. Debt Ratio Analysis in Appendix 3 illustrates that for HCSF to maximize shareholder value, they need to adopt a 40% debt ratio which results in an increase in IGR to 14.37%. This 40% debt

MGMT6021 Corporate Finance for Managers – Trimester 3, 2018 - Assignment 2 Group Members: Botha, Calder, Drennan, Lamattina

Page 6 of 27

ratio and IGR is in a similar range to that of Pepsi Co with 40% debt ratio also delivering optimal company returns as illustrated in Figure 2 above. Another advantage of adding debt to the capital structure is that debt attracts interest which is tax deductible and creates an interest tax shield which, in turn, contributes to shareholder value. With moderate debt levels, the tax advantages of debt dominate as seen in Figure 8. When debt levels reach between 40% and 50%, the likelihood of financial distress increases substantially. When

$200

HCSF they

$m

$100

should must

consider,

employ

the

trade-off theory of optimal

$50

-$50

the

maximum level of debt

$150

$0 20%

considering

capital

structure

where

“the present value of tax 30%

40%

50%

60%

PV of Interest Tax Shield (Using Rd) Debt(less Ratointerest tax shield) PV of Additonal Interest Incremental Benefit of Debt

Figure 8: Interest Tax Shields. Source: Constructed from data in Exhibits 4

savings

from

further

borrowing is just offset by increases in the present value of costs of distress”

(Brealey, Myers and Marcus 2017, 482). At present, the company has low financial distress costs. By using leverage effect to the point that the marginal value of the interest tax shield is off-set by low financial distress costs, thereby adding financial flexibility, the company increases firm value. In considering options for adding debt to the capital structure, an organisation like HCSF must consider the impact on shareholders from a personal taxation perspective. In the USA, dividend income and capital gains attract personal tax which creates a “double taxation” of corporate earnings. For a bond holder, investment income attracts personal tax on the entire amount as HCSF uses these payments to reduce its taxable income. These factors affect what individuals are prepared to pay for company stock and/or bonds. An investor, particularly at a specific time in their life, may prefer to invest in a company that retains earnings and manage a possible capital gains tax at a more suitable time. In considering the costs of financial distress with issuing debt, it is estimated using present values which are dependent on the magnitude of the costs if distress occurs and the probability of distress: Overall market value = Value if all-equity financed + PV tax shield – PV costs of financial distress Figure 8 shows the break-even point on the income tax shield benefit of debt levels is reached around 45%. The likelihood of financial distress increases as the free cash flow of the business is impacted more significantly (See Appendix 7). Direct costs of financial distress, which may include MGMT6021 Corporate Finance for Managers – Trimester 3, 2018 - Assignment 2 Group Members: Botha, Calder, Drennan, Lamattina

Page 7 of 27

bankruptcy costs, can be significant and can result in the firm’s current market value being reduced. Even if not facing bankruptcy but still facing financial distress, costs can be incurred when an organisation is tempted to engage in risk shifting strategies while shareholders may be reluctant to contribute more equity for opportunities that are safe because the shareholders only see their cash being used to pay debt holders. Finally, when facing financial distress, an organisation may enter into loan covenants which may restrict the company’s ability to make optimal financial decisions. For HCSF, a mature company with inherently risk adverse practices, issuing debt and increasing financial leverage would initially provide the financial market with positive signs that it may have confidence in its market for the potential for growth. Furthermore, the presence of debt can create incentives for management to focus on returns, “work harder, conserve cash and avoid bad investments” (Brealey, Myers and Marcus 2017, 492). In the face of high debt to equity levels beyond the breakeven point financial markets would devalue the stock as the risk profile of the company increases through its credit rating status with industry benchmarks. In the event of a downgrade to credit ratings as noted in Appendix 3, shareholders of HCSF would demand a higher rate of return ...