1. What do you think about the capital structure policies Diageo has pursued in the past. Do they make sense? How does it compare to Diageo’s competitors’ policies? Which competitors would make for the best comparison? (40%) Diageo was formed from the merger of Grand Metropolitan plc and Guinness plc. Before the merge, both companies used little debt (based on the book D/E ratio and net debt to total capital in the table below) to finance themselves which helped them gain and maintain high credit rating (A and AA respectively).
After the merge, Diageo wanted to take the same path by maintaining the interest coverage between 5 and 8 (through actions such as new debt issuance, share repurchase programs shown in figure 1) and having EBITDA/Total Debt between 30 and 35 % to avoid potential downgrade. Its market gearing is 25%. Furthermore, its debt’s pay-back period (Debt/EBITDA) shows its ability to pay off its incurred debt in a relatively short period of time. Coupled with the high multiple of cash available for interest payments over the years (EBITDA/Interest expense), the probability of a financial distress is low.
We know market gearing is equal to debt over enterprise value. Using data from exhibit 4, we find debt level equal to $6. 7 billion. Diageo can take on more debt if needed and benefit from the advantages of a high credit rating. This conservative financial policy allows Diageo to get a rating of A+ with the possibility to raise debt readily with lower promise yields and access short-term commercial paper borrowings at attractive rates.
Diageo has 4 business segments: spirits and wine business, Guinness (beer), packaged food products (Pillsbury) and fast food (Burger King).
We will start comparing by segment’s averages and aggregate the results. By looking at exhibit 4 and taking the average of the firms in composite: * Diageo’s interest coverage (5. 0) is lower than all segments’ average industry figure. Allied Domecq, Coca Cola, Gillette, McDonalds, Kellogg have a 2 to 3 times higher interest coverage. It is less risky for the lenders to finance those companies. * Diageo’s book gearing (59%) is slightly lower than average spirits’ segment figure, higher than the average book gearing of competitors in beer and beverage industry, lower than package ood and fast food industry averages. * Diageo’s market gearing (25%) is slightly lower than average spirits’ segment figure, higher than the average market gearing of competitors in beer, beverage and package food industry averages. Given its current prospects and strategy, the appropriate credit rating targeted by managers is an A. Exhibit 2 shows that spirits and wine is the best profitable business and we know Diageo’s plan to focus on this business. Let’s compare it with Allied Domecq, one of its major rivals in the alcoholic beverage industry.
Allied Domecq has a way higher book gearing and a slightly higher market gearing. However, it has a credit rating of A-. With its positive and increasing net income, this could mean that Diageo may take up more debt (probably up to its competitor ratio level) without having to fear about a potential downgrade. 2. Why is Diageo selling Pillsbury and spinning off Burger King? How might value be created through these transactions? (20%) Exhibit 2 shows that Pillsbury represents 24% of Diageo’s operating profit in FY00 while Burger King represents 10%.
Spirits and wine is the biggest division (high operating margin) of the firm and also the fastest growing with sales growth of 8% for the year. Guinness was the second division in terms of operating profit growth rate. Diageo was in the process of integrating Guinness and Spirits (with an expected cost reduction of 130 million pounds annually) which represent more than 64% of the operating profit in FY00. This would allow the firm to expand its core business and focus on the alcoholic beverage industry.
From the text, Walsh’s new strategy involves focusing on “beverage alcohol, driving growth through innovation around our unrivalled portfolio of brands and providing an improved base for sustained profitable top line growth”. Not only, Diageo considered its major rivals as potential rival bidders for firms and brands but also as potential acquisition targets. Selling Pillsbury and spinning off Burger King would allow Diageo: * to have cash handy to pay its obligations in the short-term (high amount of short-term liabilities from exhibit 6). to have the cash needed to invest in acquiring other firms for efficiencies and synergies (cost savings in manufacturing, procurement and supply, enhanced ability to reach customers through distribution systems). General Mills would pay Diageo $5. 1 billion in cash and 141 million shares (totaling $5. 4 billion). * to benefit from the synergies created by the merger of General Mills and Pillsbury as a shareholder owning 33% of the joint business. 3. Based on the results of the simulation model, what recommendation would you make for Diageo’s capital structure?
Does the model capture all of the important risk factors faced by Diageo? Would you want to adjust the model in any way? Figure 2 is an output chart of the Monte Carlo model. It shows the sum of the present value of taxes paid and the cost of financial distress based on the interest coverage. The optimal capital structure is that which maximizes the present value of cash flows to equity holders. Interest coverage of 4. 2 represents the financing mix that minimizes the expected sum of financial distress costs and taxes paid. Looking at exhibit 5, median interest coverage of 4. 4 is tied to a BBB rating. By adopting interest coverage of 4. 2, Diageo risks a downgrade. The model captures different relevant factors (quantify uncertainty, random variables, ROA for each geographical region, currency exchange rates, interest rates, 15-year sequence for trials, 10000 trials…). However, it does not take into account some factors the potential conflict of interest problems between management, debt holders and shareholders. Debt increases expected return and risk to owners and as agency costs can arise, they should ideally be incorporated in the forecasts.
The potential future acquisitions, although part of Diageo’s strategy, are also missing from the picture. Furthermore, the text says that “A distress condition imposed a one-time permanent 20% reduction in the value of the firm. There was no provision in the model for issuing equity to pay down debt when coverage fell. ” This means that the possibility for the firm to handle financial distress is minimized. I would adjust the model by taking into account the possibility for the firm to take some actions to prevent or reduce the impact of the financial distress (issue equity to pay debt when coverage fell…).
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