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Diageo Plc

Essay by   •  November 2, 2017  •  Research Paper  •  2,300 Words (10 Pages)  •  1,199 Views

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LIANG YAXIN

MA SHIYU

MA WANJUAN

LIU JIONGYU

[pic 1]

1. Introduction

Diageo plc was a world’s leading food and drink company formed in 1997 through the merger of Grand Metropolitan plc and Guinness plc, two consumer product companies. The intention was to become an industry leader by achieving cost savings through marketing synergies, cutting overhead expenses, and developing production and purchasing efficiencies.

The firm was diversified into four segments, including Spirits and Wine, beer, packaged food, and fast food industries. But since the stock price of the company did not perform well compared to the market indices, Diageo sought to focus exclusively in beverage alcohol business by selling their packaged food (Pillsbury) and fast food (Burger King) enterprises. This would create more investment dollars to purchase other leading beverage alcohol companies without taking on excessive debt, thereby expanding its operations in beverage alcohol industry and enjoy the future sustainable growth. Moreover, the acquisitions of other companies would allow Diageo to enjoy some efficiencies and synergies from cost savings in different areas such as manufacturing, procurement, supply, and distribution system. As Diageo’s business was restructured, its financial structure was different as well, and it was worthwhile to rethink the financing mix.

2. Historical Capital Structure of Diageo

The company’s capital structure strategy was crucially important in terms of credit rating and predicting financial distress. Prior to the merger of Guinness and Grand Metropolitan, both the companies were using reasonably little debt to finance their strategies which helped them to maintain high credit rating and consequently, they had a rating of AA and A respectively. After the merger, the Diageo plc succeeded to manage the capital structure of the company and reported a credit rating of A+. Further, Diageo wanted to continue the same strategy in future by maintaining the interest coverage ratio (EBITDA / Interest payments) between 5 to 8 times and EBITDA / Total debt ratio by 30% to 35%.

Followed a conservative capital structure and focused maintaining a high credit rating have many benefits. First, a higher-rating company can raise more debts with lower costs. The Treasury team speculated that, as an A+ rating company, Diageo might be able to achieve additional debt of $8 billion in one year while keeping the current rating. Yet a BBB-rating company can only borrow $5 to 8 billion in the same period. Moreover, a typical A-rating firm is subject to an interest rate, or the cost of capital, about 0.6% lower than what a BBB-rating firm is subject to in both the U.S. and U.K. bond market.

3. Static Trade-off Theory

In general, to better measure the trade-off between the benefits of use of debt and costs of financial distress, the company’s value can be calculated with the equation: Value of levered company = Value of unleveraged company + Present value of tax benefits – Present value of costs of financial distress.

The textbook version of static trade-off theory illustrates the situation that the company attempts to balance the benefits of use of debt and the cost of financial distress. Since the interest payment is a tax-deductible expense, the proper use of debt would result in reduction in tax expense. The portion of taxes that can be reduced due to the use of debt is called the tax shield. Therefore, it would be beneficial for the company to maintain a certain level of debt to reduce their cash outflows due to taxes.

However, if the company does not manage its capital structure properly, it would encounter a problem called financial distress. The problem is defined as the situation that the company cannot or has difficulties to fulfil its obligation to pay for its debt holders. If the problem cannot be resolved within a period of time, it may result in a more severe situation – bankruptcy. The situation of financial distress often incurs costs and losses. Moreover, the costs of financial distress include direct costs and indirect costs. Specifically, the direct costs include the fees payable to lawyers and accountants, other expenses incurred due to the recruitment of professionals, and time value spent on the administration during the process of bankruptcy. On the other hand, the indirect costs include the loss of sales and profits and unavailability to obtain external funding from creditors.

Since financial distress is difficult to measure and model, a popular approach, called scenario simulation (Monte Carlo simulation), is often used to quantify the costs and search for the optimal leverage level. In this model, indirect costs are represented by random variables of EBIT, interest rate, foreign exchange rate and market condition. In each scenario, only the capital structure is changed, which is represented by the change of EBIT/interest and denoted as interest coverage ratio. Financial distress occurs when the company’s interest coverage ratio is less than one due to several uncertainties that may affect EBIT. In this case, the company would not be able to pay the interest obligation to its debt holders. Whenever there is a financial distress, a permanent reduction of 20% in the value of the firm would incur as a distress cost.

After the situation of financial distress and its associated cost is defined, trails could be generated from Monte Carlo simulation by changing the interest coverage policies. In each trail, the model simulates the company’s cash flow each year and calculates the expected tax paid and cost of financial distress accordingly. The result of the simulation should contain the average tax paid and cost of financial distress in each interest coverage policy. The optimal gearing could be found in the policy that minimize the sum of tax paid and cost of financial distress. According to the result of the simulation conducted by Simpson and Williams, the sum of present value of taxes paid and distress cost appears to be minimized when the interest coverage ratio is around 4.2. Since the current EBIT/interest ratio for the company is 4.79, calculated as (Net income + tax + interest)/interest, and given that Diageo has maintained a high credit rating for a long period of time, raising more debts to reach the optimal capital structure seems to be beneficial. As a result, the value of the levered company could be maximized prior to the sale of Pillsbury and spin off of Burger King.

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