Diageo Case Study

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I. Executive Summary Diageo, one of the world’s leading consumer goods companies, was formed from the merger of GrandMet and Guinness. In 2000, the company announced its intention to sell its packaged food subsidiary, Pillsbury, and 20% of its Burger King subsidiary. Because of the restructuring opportunity, the company wanted to rethink its financing mix. In this case, the tradeoff between the costs and benefits of different leverage policies will be discussed. A simulation model was created by Diageo’s director of Finance and Capital Markets, Ian Simpson, and Adrian Williams, the firm’s Treasury Research Manager, to understand the tax benefits of higher gearing and the cost of financial distress. In this report, I will discuss the…show more content…
Low debt could help Diageo get considerable benefits. They can rise financing more readily, and pay lower promised yields. They can access short term commercial paper borrowings at more attractive rates. However, if the debt ratio is relative high, the company has to face various costs, such as direct and indirect cost of financial distress. However, because the interest of debt could shield part of earnings from taxes and strengthen management’s incentive to increase sales. Some financial analysts hold the view that companies should take appropriate debt. The tax expense could be decreased along with the increase of debt. When we put the two curves together, we can get the relationship between the debt ratio and the total cost of financial distress and tax expenses. We can see there is a optimal leverage point at which the total cost is the lowest. There are many similar theories about the optimal leverage point. Calculation of the firm value and cost of capital can also get the same conclusion. According to the Equilibrium Theory, at the optimal leverage point the PV of tax expense should be equal to the financial distress costs. Simpson and Williams’ simulation model helped us to find the point, at which point the EBIT/Interest was equal to 2.8. However, financial model does not stand for the real world. The interest coverage of 2.8 is not suitable for Diageo, because there are many defects in the simulation model. iii. Is Simpson and

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