Essay on Diageo Capital Structure Case

Decent Essays
1) Overview / Introduction
Diageo was created when Grand Metropolitan, plc and Guiness, plc merged in 1997. While the Diageo name is not well known to consumers, its brands are among the most famous including Guinness, Smirnoff, Johnnie Walker and Cuervo. The company recently decided to focus on a strategy to grow through its spirits, wine and beer businesses and divest of its Pillsbury and Burger King subsidiaries. This case study will focus on the proposed capital structure decisions of Diageo.

2) Is Diageo’s current capital structure appropriate to its new business? It believes that it has traditionally had a conservative debt policy. If so, is that policy still appropriate? Has Diageo’s capital structure been as conservative
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See table below:

FY '97 PF
FY '98
FY '99
FY '00
12,985 12,029 11,795 11,970
Operating Costs 10,982 10,659 10,278 10,088
Interest Payable 268 360 324 363
2,003 1,370 1,517 1,882
Interest Coverage
5.2 3) Why pursue a conservative debt policy?
Having a conservative debt policy increased the credit worthiness of the firm. Because the firm believes that the interest coverage ratio is a critical factor for credit rating agencies, they attempted to keep this ratio very high. Also, by having a higher credit rating they are able to access short term commercial paper borrowings at better rates. This type of short term borrowing makes up 47% of Diageo’s portfolio. By not having a strong credit rating they would not be able to lock in the low rates which would impact their business significantly.

4) What recommendation is the firm’s trade-off model for Diageo’s future capital structure?
In order to maintain its credit rating, Diageo’s Treasury team recommends an interest coverage of 5x to 8x, but the simulation-based model calculated an optimal interest coverage. Figure 2 shows minimal cost corresponding with an interest coverage of approximately 4.2. Shown in the gray bars, the cost of taxes paid decreases as EBIT/Interest
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