Diageo plc global company

Category: Company, Money
Last Updated: 25 Feb 2018
Pages: 4 Views: 297

Diageo plc is a global company now mostly known for its alcoholic beverages business. Perhaps less is known that it used to also used to be the owner of Pillsbury and Burger King. Diageo's Pillsbury subsidiary was a leading producer of packaged food products. The Burger King subsidiary was Diageo's smallest business segment that operated a series of fast food restaurants globally. In 2000, Paul Walsh, the Group Chief Executive of Diageo, announced that the company's new strategy was to focus on Diageo's core business of the manufacture and distribution of alcoholic beverages.

As a result, Diageo sold Pillsbury to General Mills for $5.1 billion in cash and 141 million newly issued shares of General Mills stock. The management also intented to exit the fast food business by an initial public offering of Burger King. These transactions could generate excess cash that allows the company to acquire and integrate other beverage firms and expand its core business. The company could therefore benefit from certain efficiencies and synergies in the future acquisitions. After the restructuring, Diageo can also focus on the alcoholic beverages business. With a clear focus, Diageo will be able to outperform competitors in the alcoholic beverage sector. In the following pages we will discuss the issue of how to optimally structure Diageo's capital going forward with its new strategic focus.

Diageo's historical capital structure Both Grand Metropolitan and Guinness had little debt prior to the merger, which allowed them to benefit from relatively high ratings on their bonds (AA and A respectively). Straight after the merger, Diageo's management announced it would maintain similar policies to the ones adopted by the two previous companies. This decision took the form of an implicit promise not to get into a debt level that would lead to a reduction in the credit rating of the company, which was aiming at interest coverage between 5 and 8. A second target was set to keep EBITDA/Total Debt at 30% - 35% level (Diageo plc Case). This tranquilized investors and financial market and as a consequence the company was given an A+ rating by the credit agencies.

Order custom essay Diageo plc global company with free plagiarism report

feat icon 450+ experts on 30 subjects feat icon Starting from 3 hours delivery
Get Essay Help

Combined with other information shown in the case, the debt and equity levels can be calculated. The original debt to equity ratio is 1 to 3 (market gearing ratio is 25%). The debt level is 6.78 billion (see appendix for detailed calculation steps). Static Trade-off Theory In corporate finance, there are a number of theorems and models that examine the effects of capital structure of a company. One powerful model suggested by Modigliani and Miller (known as M;M Second Model with corporate taxes) points out that "the value of the firm with leverage is the value without leverage plus the corporate debt tax shield from debt financing", (Corporate Finance, Laurence Booth ; W. Sean Cleary) as interest payments are tax deductible. In other words, the value of the firm increases with debt level because it generates greater tax benefit.

Meanwhile, the cost of raising debt increases significantly as too much debt obligation would lead the company to financial distress or even bankruptcy. Either of the situations would cause severe damage to company value. In this sense, debt is a "double-blade sword" in capital financing. At some point, the direct and indirect costs of bankruptcy and agency cost caused by financial distress may outweigh the tax advantage created by debt. This is referred to as the "Static Trade-off Theory". In this theory, the optimal capital structure of a company does exist, which maximizes the firm value. This optimal level can be attained when the marginal benefits of debt issuing equals the marginal costs associated with financial distress and bankruptcy.

Optimal capital structure In Diageo's case, Monte Carlo analysis simulated by the treasury group has projected the average tax bill and cost of financial distress under different capital structures in Exhibit 1. The optimal capital structure can be attained when the sum of tax paid by the company and cost of financial distress is minimized. Reading from the chart, this optimal point lies within the interval where EBIT/Interest equals 3.9 to 4.5. In other words, in order to maximize firm value, Diageo Group should adjust its capital structure to the point where interest coverage ratio is around 4.2.

Originally the debt level was 6.78 billion. If the optimal interest coverage ratio of 4.2 is applied, the debt level is adjusted (see Exhibit 2 for detailed calculation steps). The required amount of debt is 8.1 billion. If the management increases the debt level to 8.1 billion by borrowing more debt at the expense of a lower credit rating, the optimal capital structure will be achieved, as suggested by the trade off theory. The management's concern about credit rating Apparently, the trade-off model is not the only consideration when Diageo deciding its capital structure. Diageo's Treasury team maintained a relatively high interest coverage ratio in order to obtain a higher credit rating (A+ rather than BBB). A feasible credit rating would benefit Diageo in many aspects.

With higher credit rating, the company enjoyed a greater credibility in capital markets and was able to raise more capital at a lower cost when needed. As shown in Exhibit 3, the credit spread between A+ (average of A and AA) and BBB rating is around 0.6%. If Diageo were to raise a total capital of 8 billion, as suggested in the case, the yearly potential saving could be 48 million. Moreover, a higher credit rating would also grant Diageo more flexibility when issuing short-term commercial papers, in terms of both principal amount and interest rate. Besides, a higher credit rating and stronger financial position would build trustworthy image of the Diageo Group and appeal to conservative British business culture.

In this case, the management's concern about credit rating largely affects their decision making on Diageo's capital structure. If debt level is pushed up to 8.1 billion as suggested by the trade off theory, the corresponding interest coverage ratio will drop to 4.2, resulting a credit rating downgrade from A+ to BBB. Obviously, a BBB rating is not quite acceptable. As we can see, the trade off model and the credit rating issue have created a conflicting result.

Cite this Page

Diageo plc global company. (2018, Feb 25). Retrieved from https://phdessay.com/diageo-plc-global-company/

Don't let plagiarism ruin your grade

Run a free check or have your essay done for you

plagiarism ruin image

We use cookies to give you the best experience possible. By continuing we’ll assume you’re on board with our cookie policy

Save time and let our verified experts help you.

Hire writer