Diageo Plc - Case Report

Table of Contents

1.        Background        1

2.        Historical Capital Structure        1

3.        Static Tradeoff Theory        2

3.1        Theory Explained        2

3.2        Theory Applied to Diageo        3

4.        Sales of Pillsbury and Spinoff of Burger King        4

4.1        Why Divesting the Two Subsidiaries        4

4.2        Value-creation through Divesting        5

5.        Monte Carlo Simulation Model        6

5.1        Model Output and Recommendation        6

5.2        Missing Risk Factors and Limitations        7

5.3        Further Recommendation        8

References        8

1. Background

Diageo plc is a British food and drink firm that was formed in 1997 from a merger of Grand Metropolitan plc and Guinness plc, two of the world’s leading consumer product companies then. It is organized into four business segments, namely, Spirits and Wine business, Guinness Brewing, Pillsbury (packaged foods) and Burger King (fast foods). Of the four segments, Spirits and Wine is the biggest and fastest growing while Burger King is the smallest. Diageo’s stock performance has been lagging behind the broad market indices post the merger. To improve the situation, Paul Walsh, the new group CEO since September 2000, decides a new strategy to exclusively concentrate on the beverage alcohol business. To achieve the goal, Diageo has recently agreed to sell Pillsbury to General Mills by receiving $5.1 billion in cash and 33% of the new General Mills/Pillsbury business worth $5.4 billion. Several months prior to this, Diageo made an announcement to spin-off Burger King Subsidiary through IPO process by floating 20% of it in 2001 and 80% after 2002, so as to avoid the large tax impact. As the company is currently undergoing business restructure, management decides to reconsider the financial policy.

1. Historical Capital Structure

Diageo has retained the conservative financial policies of the two merged companies, by keeping low debt levels and high book equity to asset ratio. This policy reflects a relatively high credit rating of A+ for Diageo, a rough average of the two predecessor firms. The management does not want to risk a lower credit rating by increasing debt level. In order to maintain the credit rating, Diageo has set two specific targets. The primary target is to maintain interest coverage ratio within 5 to 8 times. The secondary target is to keep EBITDA/Total Debt level at about 30 – 35%.  

This capital structure has brought a few benefits to Diageo. Firstly, it enables Diageo to raise funds from capital market more readily and at a lower cost. Secondly, Diageo could borrow at attractive rates through short-term commercial paper market. So far, about 47% of Diageo’s debts were issued as short-term commercial paper with maturities of 6 months to 1 year. Despite these benefits, Diageo might be better off by moderately increasing its debt level. This will not only allow Diageo to enjoy more tax benefits on debt interest, but also provide more funds available for acquisition opportunities, so as to achieve its goal of consolidating its leading position in the industry.

1. Static Tradeoff Theory

1. Theory Explained

Leverage is two-fold that it creates both benefits and cost. Too little debt means low risk but ignores the tax shields. Too much leverage would further exploit tax shields but increase the probability of financial distress. Therefore it is crucial to determine the optimal capital structure. The static tradeoff theory states that the optimal leverage is one that maximizes firm value by balancing the benefits (tax shields) of debt against the costs of financial distress associated with increased leverage. Mathematically, it is to maximize VL in the formula below. Based on the theory, a company should analyze the amount of tax shields as well as direct and indirect costs of financial distress, and choose the debt level where marginal costs of financial distress perfectly offset the marginal benefits of tax shields.

VL = VU + PV*(Interest Tax Shield) – PV*(Financial Distress Costs)

1. Theory Applied to Diageo

As aforementioned, Diageo has historically kept low debt level in its capital structure, which may be a suboptimal policy considering the low tax shields utilized. If Diageo were to issue more debt, it could use the additional cash to acquire potential targets and grow its beverage alcohol business, at the same time realizing more tax shields. However, increasing debt will risk the credit rating from A+ to BBB and increase the borrowing cost, as the management has always concerned.

Therefore, if we were to apply the tradeoff theory to Diageo, we need to estimate the amount of tax shields due to debt interest and analyze the cost of financial distress, and then decide the optimal debt level that balances the two effects. Given the marginal tax rate of 27%, we can easily get the tax shields for the past years as following.

Table 1        Historical tax shields for Diageo (in millions)

However, it would be difficult to quantity the cost associated with increased debt, as we cannot reliably estimate the likelihood of financial distress and the magnitude of the cost if the firm is in distress. Typically, financial distress brings about direct costs including legal affairs and bankruptcy costs. It also incurs indirect costs in strategic ways, such as price war launched by competitors, declining consumer confidence and loyalty, and neglect of profitable investments by management.