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
Click here to unlock this and over one million essaysGet Access
Diageo plc is a British multinational alcoholic beverage company that produces and distributes alcoholic and non-alcoholic beverages. The company headquarter located in London, UK with a revenue base of 15.64 Billion (GBP) and 30,400 workforce worldwide. As a custodian of the most world iconic drinks, its brands include: Malta Guinness, Black Label, Smirnoff, Johnnie walker, Captain Morgan, Windsor, JB, Cîroc and Baileys just to mention but a few. The world’s largest distiller of malting, brewing until it was overhauled by China’s Kweichow Moutai in 2017. The name of its chief Executive officer is Ivan Menezes and its president (Deirde Mahlan).
What are the advantages of leveraging this company? The disadvantages? How would leveraging up affect the company’s taxes? How would the capital markets react to a decision by the company to increase the use of debt in its capital structure?
In addition, as we are comparing the profit margin and operating profit margin, we notice that interest expense, from 2006 to 2010, consumed a relative small portion of sales proceeds comparing to 2011. In 2011, the profit margin for HH is -1.46% and the operating profit margin for HH is -0.74%. Since profit margin includes interest expense in the calculation while operating profit margin does not, we can conclude that HH has about the same amount in interest expense as the amount of operating loss before interest. This finally doubles the amount of company’s loss at the end of the cycle. This big amount of interest expense leads us to study HH’s leverage ratios.
Increased leverage would increase the risk for the shareholder. This is due to the fact that an increased amount of debt would increase the financial return that investors expect. For example, if a company has no debt and posts better than expected earnings, the equity holder would get all of this benefit. If the company had some debt and posted better than expected earnings, the bond holders would get a fixed payment as usual, and shareholders would still enjoy increased profits; the problem arises if worse than expected profits were shown by Kelly Services. If Kelly Services had no debt and posted bad earnings, then the equity bears all the risk in that situation. However, if Kelly
1. What do you think about the capital structure policies Diageo has pursued in the past. Do they make sense? How does it compare to Diageo’s competitors’ policies? Which competitors would make for the best comparison? 2. Why is Diageo selling Pillsbury and spinning off Burger King? How might value be created through these transactions? 3. Based on the results of the simulation model, what recommendations would you make for Diageo’s capital structure? Does the model capture all of the important risk factors faced by Diageo? Would you want to adjust the model I any way?
Although the increased leverage decreases the amount of earnings available to stock holders from 496.9 million to 451.7 million for a total of 45.2 million dollars, it has a positive affect for the company’s tax structure. It actually reduces the company’s tax liability by 83 million dollars! Without the debt they have to pay 952.5 million dollars in taxes. However after an increase of 30% leverage, the new tax liability is 869.5 million dollars.
In general, the lower the company's reliance on debt for asset formation, the less risky the company is since excessive debt can lead to a very heavy interest and principal repayment burden. This is demonstrated through statistics such as high financial risk, low interest coverage ratios, and high debt ratios. However, when a company chooses to forgo debt and rely largely on equity, as in the case of AHP, the company does so at the expense of a tax reduction effect supplied by interest payments. Thus, a company has to consider both risk and tax issues when deciding on an optimal debt ratio.
However, the issuance of debt can have signalling effects for investors. Generally, when firms issue debt it signals to investors that the firm is in a good financial situation as the firm is able to undertake repayments of future interest.
Figure 2, which summarizes the output from the model, indicates that the optimal EBIT to interest ratio of Diageo is 4.2, because this level yields the lowest present value of taxes paid and distress costs. Diageo currently has an EBIT to interest ratio of 5, which would be slightly too high according to Equilibrium Theory. The company would benefit from an increased leverage level through tax savings as pointed out in question 2. However, a lot of Diageo’s firm value resides within brands, which are intangible assets and therefore imply a higher need of
It seems then that companies should fully leverage the company or a least come close to doing so but there is a probability that the company enters financial distress as its leverage (D/E) increases. Financial distress can be very costly for companies, and the cost for this scenario is shown in the current market value of the levered firm's securities. Investors factor the potential for future distress into their assessment of the present value (this is where PV of distress costs is subtracted from un-levered company value and the PV of the tax-shield.) The value for the costs
FIN 450 Rami Ahmed Al Hasan @16253 Elias Elkoussa @17067 May Mohammed @14325 Deena Shalab@16457 Reem Hani Arab @16185 CASE 4 An Introduction to Debt Policy and Value 1 (Table format and content from case) 0% debt/100% equity 25%debt/75% equity 50%debt/50% equity BV of debt 0 $2,500 $5,000 BV of equity $10,000 $7,500 $5,000 MV of debt 0
Nevertheless, firms have used leverage even before corporate taxes have been introduced (Maris and Elayan, 1990). This implies the existence of some market imperfections, which benefit the use of debt financing, thus enable a trade-off of the cost and benefits of debt resulting in an optimal capital structure, where marginal cost equal marginal benefits.
Swiss regulators have established themselves as being very careful regarding the demands of the country’s largest banks along with their general capital ratio norms, which are known to be highly stringent globally. This opens room for imposing stricter leverage ratio requirements over banks. To evaluate the impact of a rule making its obligatory for banks to uphold a leverage ratio ranging between 6-10%, in the third quarter of 2013 UBS reported a leverage ratio of 4.2% where as Credit Suisse reported a figure of 4.1% (at the banking industry level).
According to Smith and Stulz (1985), firms that face higher expected costs of financial distress have larger incentives to use derivatives because derivatives can reduce the present value of bankruptcy and the probability of financial distress. Firms can use derivatives to reduce the variance of a firm 's cash flow or earnings which enable firm to have sufficient cash flow to fulfill its fixed payment obligations and reduce the probability of financial distress (Aretz and Bartram, 2010; Supanvanij and Strauss, 2010). Similarly to previous studies, I have used leverage as a proxy for financial distress (e.g., Tufano, 1996; Rogers, 2002; Aretz and Bartram, 2010). Leverage is measured with the ratio of total debt to book value of assets (e.g., Coles et al; 2006).