Get instant access to this case solution for only $15
Diageo PLC Case Solution
Diageo Plc is a consumer product company operating in four major divisions; Spirits and Wine business, Guinness Brewing, Pillsbury, and Burger King. In November 1997, Diageo was formed from the merger of two of the world’s leading consumer product companies; Grand Metropolitan plc and Guinness plc. Although the merger was opposed by competitors and industry specialists, it resulted in a cost savings of nearly £290 million per year and became an industry leader. The synergistic effect came from a reduction in head office and regional office overhead expenses, and production and purchasing efficiencies and marketing synergies. Currently, Diageo is considering divesting Pillsbury, and Burger King and solely focusing on alcohol beverages division. According to Paul Walsh, the Chief Executive of Diageo, organic growth could be realized from potential acquisitions and annual capital expenditures of about £500 for the next five years. Since Diageo Plc was already the market leader in the alcohol beverages segment, acquisitions would further increase its market share and provide production and distribution synergies.
Following questions are answered in this case study solution
How has Diageo managed its capital structure? Do you agree it is conservative?
How would you apply the Equilibrium Theory* to Diageo in order to determine the firm’s capital structure policy? Would this analysis result in Diageo being a firm with high or low leverage capacity?
Using the data provided by the simulation model presented in the case and your personal assessment, what capital structure would you recommend to Diageo?
Case Analysis for Diageo PLC
An important decision faced by the Treasurer, Ian Cray, is to determine the level of capital structure after divestment from the food and fast food segments. In addition to the capital expenditures, the finance team has estimated that Diageo might spend $6-8 billion in the next three years for expansion through acquisitions. Hence, the credit rating of the company holds utmost importance in determining the ability of the company in raising financing for these expansion plans. Capital structure plays an important role in determining the credit rating of the company. The following sections of the report evaluate the optimal capital structure of the company.
1. How has Diageo managed its capital structure? Do you agree it is conservative?
Prior to merger of Guinness and Grand Metropolitan, both the firms were pretty conservative in their debt policy. The market value debt ratio of Guinness was 35.7% which has been calculated by dividing the total debt, £3,999, by the market value of equity i.e. £11,209. Similarly, the market value debt ratio of Grand Metropolitan was 52.3% (£6,541 / £12,505).The credit rating of Guinness and Grand Metropolitan was AA and A. At the time of merger, credit rating agencies were skeptical of the financial standing of the merged company since they were uncertain of the capital structure of the merged company. However, after the merger, the credit rating of Diageo was A+ which is roughly the average of the ratings of two companies.
Diageo has been quite watchful of its capital structure in order to maintain its financial standing of A+. The finance team of Diageo has realized that interest coverage ratio was a critical variable that was used by credit rating agencies to determine the credit ratings. Interest coverage ratio measures the ability of a company to pay its interest cost and is calculated by the following formula (Brigham & Daves, 2007):
Interest coverage ratio = EBITDA / Interest Expense
Where EBITDA is Earnings before Interest, Taxes, Depreciation and Amortization.
An interest coverage ratio lower than one means that the company is not able to pay its creditors whereas higher the coverage ratio, better is the financial position of the company (Brealey, Myers, & Allen, 2011). Over the years, Diageo has been following a policy of keeping the Interest coverage ratio between 5 to 8 times. In order to do that, the company would have to decrease its debt if the coverage ratio falls below 5. Conversely, if the ratio goes above 8, it would mean that the company can increase leverage. In order to regulate the level of debt, Diageo has been using various techniques of re-leveraging such as repurchasing shares financed through debt. Furthermore, Diageo has had a target of keeping the EBITDA to debt ratio between 30%-35%. Figure 1 below, taken from the case, shows how the interest coverage ratio over time. The coverage ratio before 1997 was above 12x. On 30th June 1998, Diageo repurchased shares by increasing debt and brought the coverage down to 5x to increase value while securing the A+ rating. Moreover, Diageo re-levered the firm again through a share repurchase scheme in April 1999 when the coverage ratio went above 8x. Resultantly, by keeping the coverage ratio to 5 to 8 times, the Treasury team of Diageo has been able to maintain the credit rating at A+.
Figure 1: Diageo's Interest Coverage ratio
While there are many benefits of a sound credit rating, there can be negative effects of an overly conservative financial policy. The relationship between capital structure and value of the firm is discussed in the next section. In short, it seems that the financial policy of Diageo is too conservative, and more value can be created without compromising much of the borrowing ability. Currently, the credit rating of Diageo is A+. As explained in the case, there is not much difference between two adjacent ratings in investment grade while there is substantial difference between investment grade and non-investment grade firms. Diageo can take on more debt and keep the rating at or above BBB and still be on Investment Grade and able to raise £5-8 billion to fund the expansion targets.
2. How would you apply the Equilibrium Theory* to Diageo in order to determine the firm’s capital structure policy? Would this analysis result in Diageo being a firm with high or low leverage capacity?
According to Modigliani-Miller theory, in a world with no taxes, the value of firm is independent of a firm’s capital structure (Brigham & Daves, 2007). On the contrary, in a world with taxes, the value of firm increases with the increase in debt, and hence the optimal capital structure is 100% debt as it maximizes value (Brigham & Daves, 2007). An increase in debt causes the value of the firm to increase due to tax benefit (Brealey, Myers, & Allen, 2011). Tax benefit on debt comes from the tax allowance of interest expense. Interest expense decrease the taxable income and hence, the tax liability (Brealey, Myers, & Allen, 2011). On the contrary, dividends paid to equity-holders or shareholders are not tax deductible.
Get instant access to this case solution for only $15
Get Instant Access to This Case Solution for Only $15
Save $10 on your purchase
Different Requirements? Order a Custom Solution
Calculate the Price
Related Case Solutions
Get More Out of This
Our essay writing services are the best in the world. If you are in search of a professional essay writer, place your order on our website.