How Has Diageo Historically Managed Its Capital Structure?

1. How has Diageo historically managed its capital structure?

As is true for many other British firms, Diageo has historically stuck to a relatively conservative financial policy and used reasonably little debt to finance themselves. The two firms who formed Diageo had respectively enjoyed bond ratings of AA and A prior to merger, and after the creation of Diageo, management chose to retain the policies of little debt, earning A+ for the merged firm’s debt credit which was the rough average of the two predecessor firms. An evidence is that the D/E ratio for Diageo is roughly 34.16% at the end of 2000 fiscal year.

The purpose of maintaining a high credit rating was to maintain a high ability to raise debt with lower promised yields. For example, as an A-rated company, they can probably raise an additional debt of $8 billion in 12 months, whereas if they were downgraded to BBB, the number might only be $5 to 8 billion. Further, if they were rated BB they could raise only less than $5 billion over the same time period.

Diageo also made use of Commercial Paper to finance themselves, which is another benefit of maintaining a high credit rating. This allowed them to enjoy interest rates that can be up to 25 basis points below the London InterBank Offer Rate (LIBOR).

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

One important reason is that there weren’t much synergies among alcohol beverage, packaged food and restaurant business. By selling Pillsbury and spinning off Burger King, Diageo was able to focus solely on Spirits & Wine and Beer business, which had much similarity in products and distribution channels. As a result Diageo could cut certain fixed costs, such as marketing cost and overhead. Also synergies might be created between its Spirits & Wine business and Beer business, for example, through sharing storage places and production appliances.

Plus, those two remaining businesses were enjoying high operating margins and growth at that time, while Pillsbury and Burger King were not performing as well. By focusing its resources on the more promising business sectors, enhancing the brand management of its portfolio of beverage alcohols, Diageo could make better use of resource and create value.

1. The case provides a result of Monte-Carlo simulation. Based on the result of this simulation exercise, what recommendation will you make for Diageo’s capital structure?

As can be seen from Figure 2 on p.16, the expected PV of taxes paid by Diageo plus the cost of financial distress is lowest at the point where EBIT/Interest ratio is around 4.2. We calculated Diageo’s EBIT after selling Pillsbury and spinning off Burger King to be around £1,285 million, and this gives us its interest expense as £1,285/4.2 = £306 million. Since Allied Domecq, an alcohol company with interest coverage of 5.7x is rated A-, and Carlsberg, a beer company with interest coverage of 4.1x is rated BBB, we think it might be reasonable to rate the alcohol-focused Diageo with interest coverage of 4.2x to be rated BBB, and this gives us the interest rate of 7.16%. Hence the total debt carried by Diageo was £306 million/7.16% = £4,273.74 million.

1. Create a Monte-Carlo simulation for Diageo’s capital structure yourself based on following assumptions:

The assumption we made are:

• D&A expense is assumed to be 0, because as a company producing alcohol beverage, the depreciation should be negligible compared to its revenue.
• Expected growth rate in EBITDA is assumed to be 1%. Although sales for Diageo’s Spirits and Wine business was growing by 8% during fiscal year 2000, have a closer look at its operating profits (Exhibit 2) we can see that this growth is somewhat “unusual”, because the sales actually dropped from 1,138 in 1996 fiscal year to 1,002 in 2000 fiscal year. Considering the general GDP growth, 1% might be a reasonable estimate.
• Standard deviation for growth rate is assumed to be 20%. As a mature company in a mature business sector, Diageo’s profit and cash flows should be relatively stable, but the problem here is that Diageo’s current EBITDA is around £1,285 million, and our bankruptcy rule is EBIT
• Bankruptcy rule is EBIT
• We used the credit rating provided by S&P, and we assume Diageo’s business risk would be “strong” after selling and spinning off, which mean that their bond rating would be “AA” if they can maintain a Debt/EBIT ratio smaller than 1.5, and “A” for 1.5 to 2, “A-“ for 2 to 3, “BBB” for 3 to 4, and “BB” for 4 to 5. Bond ratings lower than “BB” would not be considered because of the conservative propensity.
• Interest rate for each credit rating is listed in “InputCostofDebt” Excel worksheet.

With all these assumptions, what we did is to simulate Diageo’s EBITDA for the next 30 years. With this information, we can calculate the NPV of Diageo’s tax shield and bankruptcy cost for each amount of debt raised. Simulate for 1000 times, and we can get 1000 simulation results. Calculate the mean NPV of tax shield and bankruptcy cost of those 1000 simulation results, and we can get the expected NPV of benefit for each amount of debt raised. The capital structure with the largest NPV of benefit is the optimal capital structure we want.