Case Study: Hill County Snack Food Co.
1.1 How much business risk does Hill County face?
Hill County operates in a very competitive market where new potential entrants can be a threat to its operation either through lower price offering or lower production cost. Competition from peer companies has significant effect on its operation, because Hill County is price taker in the market, that is, increase in prices is not one of the choices it can implement. Also, due to the fact that its profitability relies heavily on cost management, an intense competition can worsen the situation of Hill County in the future. Hence, the company needs to be very efficient in order to compete with other low-cost production firms. In addition, cost management may also link to the bargaining power of Hill County over its suppliers, which plays an important role in the manufacturing cost of the firm. Whenever their suppliers have more bargaining power, Hill County would face a potential decline in its profit margin. Macroeconomics conditions also contribute to the business risk of Hill County. During an economic downturn, consumers are less likely to spend money on snacks or attend venues, where they would normally purchase snacks. This would result in declining sales. Hill County does not seem to offer as much diversification in their line of production needed, in order to diversify their exposure to macroeconomic contractions away. The change of consumer behaviour is another business risk faced by Hill County. Recent surveys have shown that, consumers tend to become more aware 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 company to alter its products. Therefore, Hill County has to conduct researches and develop alternative choices in response to such preferences and requirements, which leads to an increase of cost.
1.2 How much financial risk would the company face at each of the three alternative debt-to-capital ratios presented in Exhibit 4? The following table compare the potential financial risk faced by the company under each of the debt-to-equity ratio alternative. In general, the higher the leverage ratio is, the higher the risk level will be.
20 % Debt to Capital
40% Debt to Capital
60% Debt to Capital
The company has the same tax level across each scenario, and thus there is no difference in the relative advantage of An increase in the debt level is leading to higher The highest tax shield advantage in Tax Shield tax shield. However, in absolute terms, an increase in the tax shield benefits absolute terms to the company debt-to-capital ratio will enhance the tax shield benefit The bond rating is AAA/AA, indicating that the default risk is rather low. In terms of financing cost, comparing with the corporate bonds with same rating that pays at rates from 2.5% to 3.2%, the interest rate 2.58% is considerably acceptable. Higher debt levels are leading to higher financial distress costs for the company. However, 20% is still below the industry's average and appears as a considerable level in order to benefit from advantages that debt provides. The rating of the bond would fall to BBB indicating that the credit risk increases higher debt levels. Although the credit increasing this is still in line with the average. According to Exhibit 3 the bond This is rating drops to B. This seems rather due to high and risky and would raise the risk is concern of the management and market especially the equity holders, which are described as risk averse. Too much debt-to-capital ratio can cause severe financial distress cost to the company (details to be discussed in section 3). The 4.52 ICR indicates that the debt level is rather risky, as a significant amount of the cash flow generated by the company would be tightened up by a higher repurchase premium and a higher risk premium.
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