Diageo Case
1. How has Diageo historically managed its capital structure?
Diageo sought to maintain the low-debt (conservative) financial policies of the Guinness and Grand Met with goals to keep * its interest coverage ratio (EBITDA / Interest Payments) between 5 and 8 and * its EBITDA / Total Debt around 30-35%
Although not quite as conservative as other UK firms (with Equity/Assets ratios of 42%), it was successful in achieving these goals and retaining a credit rating of A+ (a rough average of Guinness’ AA and Grand Met’s A ratings) by re-levering the firm via * issuance of debt to repurchase and retire shares in fiscal years 1998 and then again in 1999 * and ensuring that cost of capital was managed down at
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The selling of Pillsbury would ensure Diageo 33% ownership of the General Mills/Pillsbury business without active managerial involvement and the Burger King spin off allowed floating of shares without tax penalties. In general, divesting of Diageo’s non-core business allowed for infusion of capital that allowed new internal investments and external acquisitions in businesses that can be more easily integrated to Diageo’s core competencies and can generate growth in stable, top-line revenues that are more reflective of the industry cost of capital.
However, it should be noted that Diageo’s Food and Fast Food segments had relatively stable cash flows similar to its Alcohol segments; the food segments even exhibited higher average ROA over time than industry samples (~19.8 to 21.0% vs. 15.4%). However, volatility is lower for the industry sample than Diageo’s food segments although that may be reflective of the much smaller sample size for calculating Diageo’s ROA.
4. Based on the results of the model, what recommendation would you make for Diegeo’s future capital structure? How might you adjust the recommendation from the model to adjust for any missing risk factors?
In generating countless Monte Carlo scenario outputs for tax shield gains vs. cost of financial distress, the model simulates
* $75M is deducted from equity through the creation of treasury stock, which is a contra-equity account.
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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
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?
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