Hill Country Snacks Food Company Co.

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Weighted average cost of capital (WACC) is a calculation of a firm's cost of capital in which each category of capital is proportionately weighted. All capital sources - common stock, preferred stock, bonds and any other long-term debt - are included in a WACC calculation. All else equal, the WACC of a firm increase as the beta and rate of return on equity increases, as an increase in WACC notes a decrease in valuation and a higher risk.

As WACC = Rd*(1-Tc)*Kd + Rce*Kce

Here Various terms are as following,

Rd = Rate of Debt

Tc = Effective Tax rate

Rce = Rate of common Equity

Kd = Weight of Debt

Kce = Weight of Common Equity

Again, Rce is calculated using Capital Asset Pricing Equation (CAPM) as following.

Rce = Rf + Beta (Rm – Rf)

Where,

Rf = Risk free rate of return

Beta = Measure of company’s systematic risk

Rm = Market rate of return

Broadly speaking, a company's assets are financed by either debt or equity. WACC is the average of the costs of these sources of financing, each of which is weighted by its respective use in the given situation. By taking a weighted average, we can see how much interest the company has to pay for every dollar it finances.

A firm's WACC is the overall required return on the firm as a whole and, as such, it is often used internally by company directors to determine the economic feasibility of expansionary opportunities and mergers. It is the appropriate discount rate to use for cash flows with risk that is similar to that of the overall firm.

The capital funding of a company is made up of two components: debt and equity. Lenders and equity holders each expect a certain return on the funds or capital they have provided. The cost of capital is the expected return to equity owners (or shareholders) and to debtholders, so WACC tells us the return that both stakeholders - equity owners and lenders - can expect. WACC, in other words, represents the investor's opportunity cost of taking on the risk of putting money into a company.

Here, as beta and market risk premiums are not given hence I have used Gordon-Growth Model (GGM) as it helps bypass both of this missing data.

According to GGM,

Value of stock = D1 / (r – g)

Here, r = the investor's discount rate or required rate of return, which can be estimated using the Capital Asset Pricing Model or the Dividend Growth Model.

D1= Expected dividend per share one year from now

g = Growth rate in dividends (in perpetuity

From Pro Forma statement, first for each option of debt investment, i.e., 0%, 20%, 40% and 60%, I calculated ROE and dividend payout ratio.

For ROE calculation I used following formula:

ROE = Net income / Owner’s equity (book value)

Thus, I calculated g using following formula:

g = (1- dividend payout ratio) * ROE

Once, I have got g, D1 and value of stock, I calculated Rce by substituting those value in above Gordon growth equation => Value of stock = D1 / (r – g)

Here, for Value of D1 is calculated by multiplying D0 for year 2011 for each option with its respective growth rate in dividends.

Value of stocks for each option is obtained from exhibit 5. As its given in the case that, for recapitalization purpose extra premium is needed to be paid to equity shareholders to acquire those shares. This premium increases as the size of recapitalization and repurchase increases. The recapitalization that increases debt-to-capital ratio to 20% is assumed to require a 15% premium to repurchase the required shares; 40% debt-to-capital ratio is assumed to require a 20% premium to repurchase the required shares and 60% debt-to-capital ratio is assumed to require a 25% premium to repurchase the required shares. Supply curves are upward sloping, so increasing the size of the stock repurchase implies higher premiums. Thus values of shares for 20%, 40% and 60% debt-to-capital ratio implies prices of $47.92, $50 and $52.09.

Weights of debt and capital for each option is already known.

Rates of debt for each level of debt-to-capital is given in exhibit 5 of case. At 20% debt-to-capital assumed bond rating is AAA/AA and interest rate is 2.85%, At 40% debt-to-capital assumed bond rating is BBB and interest rate is 4.4% and at 60% debt-to-capital assumed bond rating is B and interest rate is 7.7%.

As now all elements of CAPM equation are known, WACC equation can be used to calculate cost of capital and to compare relative capital structures and choose the cheapest source of capital for company.

From above calculations, it comes out that WACC for debt ratio of 0%, 20%, 40% and 60% as 11.04% , 11.31%, 11.12% and 11.16% respectively.

Thus, WACC ratio is minimum for 0% of debt capital structure and hence, Company should choose for it as it maximizes shareholder’s worth.

Recommendations

From above calculations of different capital structures of 0% debt-to-capital ratio, 20% debt-to-capital ratio, 40% debt-to-capital ratio and 60% debt-to-capital ratio WACC comes out to be around 11.04%, 11.31%, 11.12% and 11.16% respectively. Thus, its lowest for 0% debt-to-capital structure. Thus current strategy of company of using internally generated funds and equity is proper to way to go for a company. As WACC is the lowest for this figure, it increases the shareholders’ worth maximum. As WACC gets lowered, more projects are available to management for consideration as those which were previously impossible now viable. Also maintaining status quo, improves Net Present Value (NPV) for a company as margin on each penny invested increases because of this. Thus, lowest WACC is money making strategy for company.

However, company seriously needs to