Diageo, which is a London based company, has the production and distribution of Spirits and Wine, with highly recognized brands all around the world such as Johnny Walker and J&B, as its main business activity. Furthermore, the firm is engaged in the package food and fast food industry with Pillsbury and Burger King respectively. The corporation was formed in 1997 through the merger of Guinness Plc. and Grand Metropolitan. Diageo follows the norm of British Corporations of using debt as a main source of financing, conforming to a more conservative financial policy. Since Diageo relied more on equity as a source of financing its corresponding credit rating is “A+” meaning that it can borrow funds with favorable terms and easily. The firm’s conservative financial policy can be summarized by the statement in the merger announcement that the group’s policy will to manage the capital structure so as to keep the interest cover ratio between 5 and 8. The firm can retain a lower coverage ratio with no further unfavorable implications in each corresponding credit rating compared to other industries due to the stable nature of Diageo’s portfolio of brands. The firm’s main intention is to sell the packaged food subsidiary (Pillsbury) and 20 per cent of Burger King with a subsequent spinoff of the remainder of the subsidiary after December 2002. Referring to the capital structure of Diageo, we can mention that applying the trade -off theory we found that the firm had a higher debt than the optimal one suggested by the theory. This conclusion was enhanced by the Monte Carlo Simulation used by the firm’s executives in order to identify the capital structure to identify the coverage ratio that minimizes the taxes paid and the financial distress costs. When constructing the model we believe some of the assumptions were unrealistic. The model should have been adjusted to include factors such as the fact that the credit spreads for different ratings are not fixed. Generally the model should be adjusted to include not only factors relevant to the firm’s financial position but also other macroeconomic and business risk factors. What is more the research conducted revealed that company can add value from the divestment by improving its liquidity position, through tax benefits from the sale of shares of Burger King, cost savings from integrating distribution channels, lower volatility of earnings by focusing on a relatively “unrivalled” sector and economies of scale through acquisitions in order to become the leader of the industry.
Before getting into details about the trade-off theory of leverage we have to point out the meaning of bankruptcy costs. Specifically, with that term we refer to any cost incurred by a firm in case of bankruptcy. In these costs we include any legal and accounting expenses along with further costs from not retaining customers, suppliers and employees. What is more, the firm might be forced to liquidate its assets for less than they would worth if the firm were to continue its operations. In fact even the threat of bankruptcy could cause serious problems to the operations of a firm by losing customers, skilled personnel and struggling to raise funds with reasonable terms. This implies the fact that companies with higher levels of debt are vulnerable to bankruptcy problems and financial distress resulting in a decline in the firm’s market share. These facts led to the deployment of the trade-off theory.
According to the trade-off theory, there is a trade-off between the benefits of the debt financing due to the fact that the interest payments’ tax-deductible feature and the higher interest rates along with higher bankruptcy costs. Specifically, the theory suggests that the value of a levered firm is equal to the value of an unlevered one plus the value of any “side effects”. The term “side effects” refers to the tax shield due to the favorable tax treatment...
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