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Essay about Diageo Case

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    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 each country level in keeping with its “Managing for Value” approach to employing capital . What is the static tradeoff theory? How would you apply it to Diageo’s business prior to the sale of Pillsbury and spinoff of Burger King? The static tradeoff theory suggests that firms try to balance the costs of financial distress against the benefits of a higher debt (higher tax shield as introduced by the MM theory) when making capital structure decisions to determine how much debt to use for funding operations and making capital investments.

    Costs of financial distress include both bankruptcy costs (poor cash flow leading to bankruptcy in a highly levered position) and non-bankruptcy costs (increased cost of capital, ability to advantageously use commercial paper, suppliers demanding stricter payment terms etc. ) Diageo has maintained high credit ratings and kept its interest coverage high. It could maximize its tax shield by increasing its debt levels and using its cash positions to aggressively bid for targets like Seagram to grow its beverage alcohol business. . Why is Diageo selling Pillsbury and spinning off Burger King? How might value be created through these transactions? Diageo wants to focus exclusively on the beverage alcohol industry. Pillsbury and Burger King were in the packaged and fast foods segments, respectively, and did not fit with Diageo’s two larger spirits/wine and brewing segments due to incompatibilities with shared production, marketing, channeling, and cost savings.

    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 outputs for key financial metrics such as EBIT and interest payments, which also determines taxes paid, interest coverage ratios, and firm credit ratings. In general, the greater leverage Diageo uses in its capital structure, the greater the interest payments and higher probabilities for distress; but this also corresponds to greater tax shields that can be realized.

    As variable inputs, the model identifies three primary risks: the ROA (which relates to operating cash flow), the currency exchange rate, and interest rates (which determine interest expense). Based on statistical results of the model as is, we recommend that Diageo continue to maintain their interest coverage ratio of 5 to 8; as concluded in the simulations, the likelihood of financial distress is low within this range. This reflects the stability of Diageo’s operating cash-flow and ability to secure good credit ratings / nterest, while also allowing Diageo to realize 0. 5 to 1. 0 B (in PV terms) of tax savings through leverage. One risk that is not considered is the lost opportunity cost for Diageo to utilize additional leverage for acquisitions of new companies or reinvestment into their core business. While the model focuses primarily on the tradeoff between tax shield vs. financial distress, it does not directly account for potential benefits to shareholder value through increases in Diageo’s asset base. Diageo estimates its ROA, defined as EBITDA / Asset, at 17. 7%.

    As part of Diageo’s growth strategy for the next 5 years, the firm calculates “midrange” of $2. 5B in acquisitions over the next 5 years. Assuming that these funds are generated through 100% leverage, we estimate that Diageo can increase its sales revenue and EBITDA at a correlating rate against the increase of $2. 5 B acquisitions to its asset base over 5 years. While cost of debt and interest payments will also increase accordingly, net income and free cash-flow to equity will increase at a greater rate as Diageo’s ROE of ~22% is greater than it’s anticipated cost of debt even at BBB ratings.

    Greater expected cash flow to equity would contribute to increasing market cap and share prices. Furthermore, the enhanced risk of financial distress can by offset by the $1B marketing funds that serves as a form of contingency. Given these new considerations, we recommend Diageo pursue its acquisition targets through increasing current leverage ratios. See Exhibit 1 for pro-forma. 5. Why do you think the management cares so much about the firm’s debt rating?

    Investment grade firms with strong debt ratings were able to raise greater capital more easily and paid lower interest yields than non-investment grade firms. It was estimated by Diageo management that if the firm was rated at BBB, they could only raise $5 to $8 B in debt within 12MO period as compared to an additional $8 B that can potentially be raised if the firm was rated as an A- borrower. Furthermore, better debt ratings also ensured lower rates for short-term papers, which were selling up to 25 basis points below LIBOR, as well as a firm’s ability to lever up within the commercial paper market.

    As 47% of Diageo’s debt was short-term, maintaining their ability to secure short-term borrowings greatly depended on their ability to secure a higher debt rating. In short, higher debt ratings allowed Diageo to secure cheaper debts, avoid financial distress (by avoiding high interest payments), and maintain higher interest coverage ratios. However, given Diageo’s stable industry and strong brand, they are expected to secure debt more relatively easier at a lower rating than other firms.

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