Diaego Plc

Context:

Diageo’s principal activity is manufacturing and distributing spirits and wine business with high recognized brands in the world like Malibu, J&B or Johnnie Walker. Diageo was formed in November 1997, following the merger of Guinness plc and Grand Metropolitan. Diageo consists of four main businesses: spirits and wine business, beer business with Guinness Brewing, Pillsbury with global food giant boasting four mega brands, and Burger King with fast food business. The principal matter to Diageo is focusing in a relevant portfolio of brands in alcohol business.

To concretize this goal in 2000, Diageo proclaimed the sale of one of your small business: the Pillsbury to General Mills, Diageo also announced its intention to sell 20 percent of its stake in Burger King.

4. If you apply the text book tradeoff theory to Diageo, what can be implied about the optimal capital structure of Diageo prior to the sale of Pillsbury and spinoff of Burger King?

The tradeoff theory is explained by a tradeoff between the interest tax shield and the cost of bankruptcy. The company chooses how much debt and equity finance to use by balancing the cost and benefits of these two types of financial way. If we apply this model to Diageo, in a historic structure based in lowers debt’s ratios we can see the optimal debt ratio can be higher that historical debt ratio. The Diageo should borrow up to the point where:

Marginal benefits of the tax shield =Marginal cost of financial distress

When this happen the debt increases the firm value by reducing the corporate tax bill as we can see in the next chart:

In Diageo case, the major issue is the measure of bankruptcy costs and the uncertainty of operating income. To resolve some of these problems the investigators that the case talks about present some important results. The uncertain of operating income can be resolve by observe the historical cash-flows, and they concluded that they are relative stable in the alcohol business.

So, if we apply the tradeoff theory to Diageo case, we can conclude that they are in the left of optimal debt ratio so they can have a bigger debt ratio.

4. What does the model developed by Diageo’s treasury group recommended for Diageo’s future capital structure?

The model outcome is a relation between EBIT divided by interest payments and Present value of tax payments and financial distress estimated costs. This relation indicates that Diageo will minimize these costs if interest coverage ratio decreased to around 4.2. This means that debt should increase, as we saw that it was never lower than 5 (figure1).

But this conclusion will lead to another tradeoff: lowering interest coverage ratio under 5 will mean deterioration of conditions offered by funding entities, as Diageo’s rating will be worse. Then again, interest payments for the same amount will increase and consequently, interest coverage ration increase.

3. Does the model capture all important risk factors faced by Diageo?

The model identifies the main risks faced by Diageo in this project. It considers the financial risk, that are the implying costs a financial decision might have, in other words, the trade-off between the advantage