Case 2 - Justin Cochran

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Wright State University *

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FIN-4210

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Finance

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Jan 9, 2024

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docx

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Justin Cochran Case 2 9/27/2023 1. Business and Financial Risk: Hill Country has quite a few business risks faced by the company, such as not having a proper department for Operational Management, as well as the CEO being directly involved in making the budgets or the company, which makes the company look dysfunctional regardless of how well they have performed in the past. The management that the company does not have the expertise to manage unfavorable variances. For the 20% debt-to-capital ratio there is less risk, due to its interest coverage being 36.90. However, the 40% debt-to-capital ratio is riskier than the 20% ratio as its interest coverage is lower, at 11.82. The 60% debt-to-capital ratio is the riskiest out of all of them as its interest coverage is 4.52. At the 20% debt-to-capital ratio, its EPS (Earnings Per Share) increased from $2.88 to $3.19 and its DPS (Dividend Per Share) increased from $0.85 to $0.96, which looks good, but it is not the most valuable. At the 40% debt-to-capital ratio its EPS increased from $2.88 to $3.31 and the DPS increased from $0.85 to $0.99, which makes it the best value that the shareholders could get out of it. Finally, the 60% debt-to-capital ratio has the EPS increase from $2.88 to $3.11 and the DPS to $0.93, making it the lowest increase out of all the debt-to-capital ratios and thus the least desirable. 2. Debt-to-Capital Structures I would recommend that Hill Country uses the 40% debt-to-capital structure. The main advantage to adding debt to the capital structure, at least for the 40%, is that it decreases the income taxes to $49.2, though it also increases the interest expense to $12.8, which would lead to an increase in the return on equity. Though compared to 20%, where the taxes only decrease to $52.3, and a small increase in taxes to $4.1, I’d say 40% is a fair deal. The reason 60% isn’t used is because while it does have the lowest tax decrease, its interest expense increases to $33.5, which doesn’t seem very desirable. Issuing debt can lead to tax-deductibles, which is a reduction in the tax obligations from a taxpayer’s gross income, so using debt can cause a decrease in taxes. However, debt can also affect financial distress, as the increase from the debt can affect the debt-to-equity ratio, which in turn can increase the possibility of the company going bankrupt. If Hill Country were to increase its financial leverage, then the financial markets will likely assume it is doing well and investors may become more interested in investing in the company.

3. Capital Structure One way that Hill Country could begin using a more aggressive capital structure is by increasing their debt level and decreasing their equity level. They could do this by borrowing money from a bank, which they would then have to pay off later. The best borrowed money they could get is a bond, as they would be able to set the interest rate and schedule when the payments would be due. They could alternatively get a bank loan, but the downside is that the banks control the interest rates on their loans, as well as any other terms the banks have set. 4. Persuasive Argument Seeing as Hill Country’s management has one major goal, which is to ensure that shareholders wealth is maximized, I could raise the leverage ratio, which can help them achieve their goal. First, they could use the issued debt to repurchase stock, which can help bring the shareholders some tax benefits, which helps equity holders manage their wealth more efficiently. Regarding the company’s strong commitment to efficiency, the issuance of debt can provide Hill Country with a sizeable tax shield as the interest payment is deducted, reducing their expenses as a side effect. Since the company is also very risk averse, they can also issue debt into their capital structure to stabilize the cash flow to a point where the managers can choose which payments are suitable to certain financing requirements, which can allow to at least control the amount of risk the company is exposed to.

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