Introduction and Background
Diageo was formed in 1997 through the merger of two consumer product companies Grand Metropolitan plc and Guinness plc under the strategy of reducing costs through marketing synergies, cutting overhead expenses and increasing production and purchasing efficiencies. The new merger wanted to concentrate solely on the beverage alcohol business, so it sold its packaged foods (Pillsbury) and fast food (Burger King) businesses. While the mandate for Managing for Value came from the highest levels of Diageo, the treasury team was given the task of establishing the cost of capital for each of the different areas the company operated. The team had to create a simulation model which should consider new finance approaches, treasury functions to focus on, what the firm's risk footprints will be, how to calculate cost of capital and finally how to optimally structure capital.
How has Diageo managed its capital structure?
Both Grand Metropolitan and Guinness had little debt prior to the merger, which allowed them to benefit from relatively high ratings on their bonds (AA and A respectively). Straight after the merger, Diageo's management announced it would maintain similar policies to the ones adopted by the two previous companies. This decision took the form of an implicit promise not to get into a debt level that would lead to a reduction in the credit rating of the company, which was aiming at an interest coverage between 5 and 8. A second target was set to keep EBITDA/Total Debt at 30%-35% level. This tranquilized investors and financial markets and as a consequence the company was given an A+ rating by credit agencies.
Table 1 presents some key financial indicators extracted from the case. As it can be observed, Diageo's debt level is low (market gearing level is around 25%), which together with the favorable credit rating (A+) puts the company in a good borrowing position in case of such need. From the data shown in Table 2 we can see that the company's good interest coverage ratio (EBITDA/Interest payable) is mainly due to high EBITs over the years (�40 million in 2000) compared to the interests to be paid (�3 million in 2000).
As we can observe in Table 1, Diageo is fulfilling the implicit promise it has made to the public maintaining the EBITDA/Total Debt ratio within the 30%-35% interval (34% in 2000) and the interest coverage value between 5 and 81. It can be noticed though that in both indicators Diageo has reached the promised limits and an eventual decrease in the company's EBIT next year could lead to an interest coverage below 5, which would have as a consequence a downgrade of the company's credit rating. On the other hand, having an EBITDA/Total Debt ratio around 34% means that the company is either reducing its total debt thus not taking full advantage of its tax shield or increasing its EBITDA, which results in paying more taxes.
1 For our calculations in table 2 we used EBIT/Total Debt since there was no information about depreciation and amortization in Diageo's Financial Statements, and consequently in 2000 the interest coverage we obtained was 4.79 rather than 5 as shown in Exhibit 4 of the case.
Table 1. Diageo's financial data for 2000
Table 2. Financial Statement Data between 1997 and 2000
What does the Equilibrium Theory argue? How would you apply this theory to Diageo? What capital structure would result?
The Equilibrium Theory argues that the value of the leveraged value of a company depends on the un-levered (full equity) value of the firm plus the present value of the tax shield minus the present value of the distress costs. The present values of tax shield and the distress costs vary with different levels of debt. Debt does not affect the un-levered value of the firm due to the fact that debt finance does not affect the operating risk of the company, but it does affect the financial risk. As the leverage increases the expected return from equity...
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