Diageo Case 625763

Diageo Case discussion Question 1: How has Diageo historically managed its capital structure? What sorts of financial "targets" has the Diageo treasury staff been managing toward?  

Followed a conservative capital structure and focused more on the same. Had more equity and less debt in their capital structure. Focused on maintaining a high credit rating and was more concerned with the decrease in the credit rating due to more debt in the capital structure. Targets

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Took all steps to keep the interest cover ratio (EBITDA/interest payments) within a band of 5 to 8 times which got itself a credit rating of A+, the rough average of the two predecessor firms. As a secondary target, it sought to keep the EBITDA/ total debt to about 30% to 35% to maintain A+ credit rating The firm adjusted its coverage ratio through combination of debt issuance, repurchases and other large transactions to maintain the credit rating

What are the types of financing decisions that the firm would routinely make?

a judgment made regarding the method of raising funds that will be used to make acquisitions; it is based on an entity’s ability to issue and service debt and equity securities When making the financing decisions, the company must determine and take into the best financing mix or capital structure of the company. So in this sense and in this case, the best choice is the capital structure that allows the optimal valuation of the company for the shareholders. The important elements to consider in the financing decisions include    

Nature and riskiness of the business operation Capital structure (debt-equity ratio desired) The length of time the assets will be needed Cost of alternative financing

The company has to keep the above factors in mind to identify the sources of finance and determine which is best for the project/growth and for the company. In case of Diageo, it need to move in the direction of the new strategy and focus on beverage alcohol division, driving growth through innovation around the unrivalled portfolio of brands and providing an improved base for sustained profitable top line growth. To achieve this goal/strategy, it needs to sell its Pillsbury division which would fetch $5.1 billion cash plus 141 million newly issued shares of GE. It can go by the option of floating Burger King Divisions in different parts to get the tax advantage. Further the company has got large balance of marketable securities in its balance which it can use In the initial periods, it can focus more on organic growth by increased sales of the products and use the funds got from the sale of the above divisions, sale of marketable securities since Diageo is already in a strong position in the market with respect to the beverage alcohol division. That way, it can maintain its capital structure and credit rating On a long term prospective, it can go ahead with acquisitions. To fund the acquisitions, it can use the cash it has accumulated by way of organic growth to enable it to maintain the credit rating and the capital structure. It may need to take the decision of raising equity to provide funding for its long term growth. However, it needs to evaluate its decision of taking additional debt for a long term growth which may be made in the interest of the shareholders of the company

So preciously it needs to evaluate the outcomes of the static trade off theory when deciding between debt and equity

Do Diego's financial/treasure targets seem reasonable? use in this regard?

What sorts of benchmarks would you suggest they

Diageo follows a policy of conservative capital structure with less debt and it makes sure it maintains a A+ credit rating. This allows the company to get more debt borrowing eligibility and get more funding. It also allows the company to an advantage of accessing short term commercial borrowings at attractive rates. However, the downside is that the company is losing out its benefits of getting tax advantages. The company needs to evaluate the outcomes of the static trade off theory and estimate the cost benefit analysis of the existing capital structure vs having additional debt in its capital structure to evaluate the reasonableness of the existing capital structure With respect to the targets set by the treasury, it seems reasonable as it has been designed to maintain the capital structure and the credit rating of the company which seems to the important strategy of the company. But it may throw up a different picture when this is compared with the other peers in the industry The company also needs to look at industry benchmarks such as capital structure of the peers, credit rating of the peers, debt policies of the peers and interest coverage ratios of the peers

Question 2: What is the "Static Tradeoff Theory"? What are the 3 factors leading to the simplest form of the Static Tradeoff Theory?

The static trade-off theory, which focuses on the benefits and costs of issuing debt, predicts that an optimal target financial debt ratio exists, which maximizes the value of the firm. Factors:- We need to consider the benefits of debt financing as well as downside of debt financing which offsets. The optimal point can be attained when the marginal value of the benefits associated with debt issues exactly offsets the increase in the present value of the costs associated with issuing more debt. Benefits of debt financing 

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The benefits of debt are the tax deductibility of interest payments. The tax deductibility of corporate interest payments favors the use of debt. This simple effect however, can be complicated by the existence of personal taxes and non-debt tax shields. Another benefit of debt is that it mitigates the manager/shareholder agency conflict. Corporate managers have the incentive to waste free cash flow on perquisites and bad investment. Debt financing limits the free cash flow available to managers and thereby helps to control this agency problem.

Downside of debt financing 

The costs associated with issuing more debt are the costs of financial distress and the agency costs triggered by conflicts between shareholders and debtors. Costs of financial distress are likely to arise

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when a firm uses excessive debt and is unable to meet the interest and principal payments. Decrease in credit rating, higher interest costs due to low credit rating and lower debt financing eligibility, lack of financing flexibility in times of need

http://jbsq.org/wp-content/s/2012/09/JBSQ_Sept2012-1.pdf http://www.tc.umn.edu/~murra280/WorkingPapers/Survey.pdf

Question 3: If one applies the static tradeoff theory to Diago, what "optimal" capital structure policy do you think would likely result? Does this seem to be the only consideration that Diageo is using in deciding optimal capital structure?

We added an extra constraint that if interest coverage ratio is below 2, cost of debt will be set at 8% as the rating may experience another decrease as interest coverage falls. We summarized the results of computing different interest coverage ratio into the graph below. WACC proves that if Diageo were to take on more debt, they will still be solvent. As we can't quantify distress cost, we are not able to find the optimal D/E ratio for Diageo through our model. However, our recommendation for Diageo's interest coverage maintenance would be between 3.5 to 4.5. If we take on too much debt, our equity value will shrink at a much faster rate. If we reach over 4.5, our equity value is barely growing anyways. Even with an interest coverage ratio, Diageo's forecasted market gearing is only at 22% which is much lower than its competitors. Diageo's main focus lies with alcohol and beer as they are planning to sell their package food division, Pillsbury, and it is also pricing Burger King on the market due to the fact that they would want to concentrate more on Alcohol and Beer industry. From a numerical point of view, Diageo is able to generate 3.5 times more income from spirits and wines than from beer. Therefore multiples from the alcohol industry should be used to compare to Diageo Plc. In addition, rating agencies evaluate companies relative to industrial standards. It provides a good reason for Diageo to explore possibilities by studying their competition. Market gearing ratio reveals Diageo has taken on the least debt when comparing as percentage of the total of short term and long term debt and market value of equity. Allied Domecq has a market gearing of 29% and still maintained an A- for credit rating. Furthermore, they have a book gearing of 88% which is 49% higher than Diageo. We can deduce that up to this point, Allied Domecq has not incurred any distress cost At present, Diageo interest coverage ratio is 5x times. Based on figure 1 and figure 2 which are based on the results of the simulation, it can reduce the interest coverage ratio to the range of 4.2, the next lower range and it should not go below that based on figure 1. This amounts to increase in the debt by 16% in the capital structure which amounts to tax shield on the interest costs to that extent. If it takes too much debt, the equity value will shrink at a faster rate. Further distress costs will increase if it takes more debt, thereby diminishing the value of the firm. At the present, it can focus more on organic growth by increased sales of the products and use the funds got from the sale of the above divisions, sale of marketable securities since Diageo is already in a strong position in the market with respect to the beverage alcohol division. That way, it can maintain its capital structure and credit rating. It need not go and in fact it is not necessary for the company to go for additional debt which may not be preferred by investors which may decrease its credit rating and riskiness.

To fund the acquisitions, it can use the cash it has accumulated by way of organic growth to enable it to maintain the credit rating and the capital structure. At this point too, it may not be necessary for the company to go for additional debt It will always be better for the company to take the additional debt at the point where it starts losing its position in the industry and its sales start declining ie, at a really needy time when the company is in need of funds. There is no point in for going for an additional debt just to reach the optimal structure when the company is not in need of funds

Question4: Why do you think Diageo is selling Pillsbury and spinning off Burger King? In case of Diageo, it need to move in the direction of the new strategy and focus on beverage alcohol division, driving growth through innovation around the unrivalled portfolio of brands and providing an improved base for sustained profitable top line growth. To achieve this goal/strategy, it decided to sell its Pillsbury division. Regarding Burger King, it decided by the option of floating Burger King Divisions in different parts to get the tax advantage. It decided to float 20% of Burger King so that the company does not trigger a significant tax charge. After 2002, it decided to float the remaining, since there will be tax regulations that say after 2002, it will not incur any taxes for the same

Question 6 Does the model capture the "dynamic" nature of the capital structure problem well? What features, if any, do YOU feel may be missing from the model? The model is more focused more on the debt rather than the equity. It is important for the model to stimulate the equity as it is an important component of the capital structure. It does not take into the effect of return to the equity investors upon taking more debt. There is no provision in the model for issuing equity to pay down debt when the interest coverage fell. Even though the model takes into the outcomes of the static trade off theory such as the distress costs and the tax and various uncertainties such as return on assets for each geographical region, currency exchange rates and interest paid in firm’s debt, it does not explicitly state the effect of distress costs and the tax shields on the various levels of cost of debt. It also does not state the relationship between the distress costs and tax shields on the various levels of debt. Also it does not state the effect of cost of debt on the capital structure and the cost of equity. It does not help us to look at different combinations of debt and equity in the capital structure to help the company to easily arrive at the optimal capital structure Further the model takes into the interest costs at the present credit rating. Even though, it shows higher interest costs at higher debt level, it does not seem to take into the impact of the increased interest payment and effect on tax due to the decrease in the credit rating upon taking more debt. The model to accommodate the same can add a % of additional provision to for the same It does not take into the effect of the industry factors and the macro economic factors which may influence the interest costs and debt levels Since Diageo is a UK based firm, the model can be set up to link the interest rate to the UK interest rate rather than the US interest rate

What does the model developed by Diego's treasury group recommend for Diego's optimal capital structure GOING FORWARD? The treasury department used the Monte Carlo stimulation which was based on the outcomes of the static trade off theory to enable the company to utilize the tax shield on the interest costs which can be achieved by taking on more debt. It did 10,000 iterations and did a graph taking into the the interest coverage ratio, PV of the taxes paid and distress costs. The optimal capital structure for the company would be at the point where the cost of distress and the tax paid are the least. This can be achieved at the range of 4.2 based on the inputs from figure1 and figure 2. This means that Diageo has got a provision to add more debt or take more debt in its capital structure.

Historical Capital Structure   

Followed a conservative capital structure and focused more on the same as it is the approach followed by UK companies. Had more equity and less debt in their capital structure. Focused on maintaining a high credit rating and was more concerned with the decrease in the credit rating due to more debt in the capital structure. Maintained an interest coverage ratio of between 5 to 8