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How Has Diageo Historically Managed Its Capital Structure?

Case Study How Has Diageo Historically Managed Its Capital Structure? and over other 29,000+ free term papers, essays and research papers examples are available on the website!

Autor:   •  November 5, 2018  •  Case Study  •  2,065 Words (9 Pages)  •  26 Views

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Q1 How has Diageo historically managed its capital structure?

1) Diageo followed a conservative capital structure since the merge of Guinness and Grand Met, and that means it employed more equity and less debt in its capital structure which can be demonstrated by the following table:

Diageo’s equity to asset ratio was 42% in year 97 and remained around 30% for the year 98 to year 00, indicating a comparatively conservative financial policy.

2) Diageo paid much attention to maintain a high credit rating. Diageo communicated its decision to investors and rating agencies in the merger announcement by stating it would manage actively the capital structure so as to keep the interest cover ratio within a band of five to eight times and remain its credit rating of A+.

Since the material doesn’t contain sufficient information for us to calculate the amount of depreciation for year 97 to year to 00, we have to ignore depreciation when we are calculating EBITDA of Diageo. The table above shows that Diageo’s interest coverage ratio stays at around 5 from year 97 to year 99, although the ratio was slightly below 5 in year 00, which means Diageo kept its commitments.

Q2. What is the static tradeoff theory (textbook version)? How would you apply it to Diageo’s business prior to the sale of Pillsbury and spinoff of Burger King?

1. What is the static tradeoff theory?

The static tradeoff theory, which focuses on the benefits and costs of issuing debt, predicts that an optimal target financial debt ratio exists, which maximizes the value of the firm. This theory is often set up as a competitor theory to the pecking order theory of capital structure. It states that there is an advantage to financing with debt, the tax benefits of debt and there is a cost of financing with debt, the costs of financial distress including bankruptcy costs of debt and non-bankruptcy costs (e.g. staff leaving, suppliers demanding disadvantageous payment terms, bondholder/stockholder infighting, etc.).The marginal benefit of further increases in debt declines as debt increases, while the marginal cost increases, so that a firm that is optimizing its overall value will focus on this trade-off when choosing how much debt and equity to use for financing.

b. How would you apply it to Diageo’s business prior to the sale of Pillsbury and spinoff of Burger King?

Under the assumption of static tradeoff theory, we can find an optimum capital structure that can maximize the value of the company. In order to find the optimum capital structure, we use the capital structure of the comparable company as a reference. And the question is what kind of comparable company we should use as the reference. We conclude that we should use the capital structure of Allied Domecq under the alcohol industry as a reference. The reasons are listed below:

First of all, we believe that since Diageo is seeking to be in a strong position to expand its alcohol business and is planning to integrate the two largest segments to focus on this part of business, so we should use the capital structure of companies in alcohol industry as the comparable capital structure.

Secondly, Allied Domecq has relatively good performance in the alcohol industry with a ROE of 25.7% and market to book ratio of 18. It indicates that Allied Domecq has maximized its value under such capital structure.

Thirdly, Allied Domecq also has close credit rating as that of Diageo. Its credit rating is A-, so it is more appropriate to compare Diageo with Allied Domecq under similar credit rating.

If we use Allied Domecq’s capital structure as the target capital structure for Diageo, we find that Allied Domecq has a higher interest coverage ratio of 5.7. Currently Diageo has an interest coverage ratio of 5, so Diageo should try to increase its interest coverage ratio to 5.7. And Diageo can take following measures to increase its interest coverage ratio:

First, it can expand through organic growth, thus, increasing its EDITDA. Second, it can repay some debt using its operating cash flow, as a result, the interest expense will decrease resulting a higher interest coverage ratio.

3. Why is Diageo selling Pillsbury and spinning off Burger King? How might value be created through these transactions?

(1) There were several important motivations for selling Pillsbury and spinning off Burger King.

Firstly, according to the material, we know that the company’s new strategy: “focuses on its beverage alcohol business, driving growth through innovation around its unrivalled portfolio of brands and proving an improved base for its sustained profitable top line growth”. Pillsbury accounted for only a quarter of Diageo’s operating profits and it was too small to prosper on its own, while Burger King was the smallest part of operating profits. The company could not focus on several business at the same time. So, the primary reason was that the company wanted to concentrate on its beverage alcohol division and aimed to be the industry leader in the beverage alcohol market.

Secondly, there was an immediate cause of this decision. From Exhibit 3, we can see that since the 1997 merger, Diageo’s stock price had trailed the broad market indices. This lag trended to be significant by early 2000, then in the late 2000, Diageo announced to sell Pillsbury and spin off Burger King. It seemed that the executive had to take actions to deal with the sharp decline of the stock price and it was apparent that after these actions, the stock price of Diageo began to climb and the gap between it and the rest of the market got smaller.

(2) Selling Pillsbury and spinning Burger King can benefit the company as a whole for the following reasons:

Firstly, it will create value through promoting organic growth. Since Diageo was already in the process of integrating Spirits and Guinness which accounted for 65% of the operating profits in FY00, it would allow the company to concentrate on and expand its core business. According to the material, the integration could benefits Diageo by reducing costs of 130 million per year. Being exclusively in the core business would allow the company to save costs on warehousing, overhead expenses by reducing workforce, and increase production and purchasing efficiency through economies of scale.

Secondly, it will also create value because it allowed Diageo to catch the opportunity of growth from acquisitions. Though these transactions, Diageo would have cash in hand, which could be use to invest in acquiring other firms when the opportunities arose. General Mills would pay Diageo $5.1billion in cash and it allowed Diageo more flexibility to acquire other beverage alcohol companies without being reliant on issuing new debt to finance the purchases. As is mentioned, issuing new debt would increase risk of downgrading and it did not conform to Diageo’s conservative financial policies, too.

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