HBS Case Diageo Plc

University Degree Business and Administrative studies

Diageo Plc

Capital Structure Analysis

RSM433 Advance Corporate Finance

Jingtian Huang 996014272

Wei Jiang 994633624

Yizhou Shen 996563801

Tian Liu 996582764

Xinyu Ma 996127613

Table of Contents

Executive Summary

Diageo Plc is a London based consumer goods company. Diageo was formed from the merger of Grand Metropolitan and Guinness in November 1997. The business split among four segments: Spirits and wine, Guinness Brewing, Pillsbury and Burger King.

Consider the fact that Grand Metropolitan and Guinness are both conservative in its leverage ratio which is far below industrial average. Historically, Diageo Plc has proven as a company who take a risk neutral approach in managing its right-hand-side of balance sheet.

By applying trade-off theory, which suggests firm should seek out an optimal structure that best balances tax benefit to expected distress cost, we have discovered that Diageo is suitable for taking on more debt. It has a lower market gearing when compare to other competitors in the industry. Assuming they have not gone into distress and still maintaining an A- rating, Diageo have room for debt as its market gearing is 4% less when compare to others in the market. Our estimate for interest coverage ratio ranges from 3.5 to 4.5 due to equity maximization.

The Monte Carlo simulation is suggesting maintaining an interest coverage ratio of 4.2 due to the fact that this is the point where tax paid and expected distress cost is most minimized. However, as sophisticated as Monte Carlo might be, there are still several features related to dynamic nature of the capital structure problem it does not capture. Some of the reasons are “year-end zero cash balance” and no inputs that relate to future acquisition.

Clearly trade-off theory is not the only consideration for Diageo, their expansion and acquisition plan needs financial flexibility to support it. Diageo’s strategy is to sell Pillsbury and Burger King and focus more on alcohol and beer industry. They need at least a BBB rating to support their estimated $8 billion in the upcoming years because when fall below to BB, the ability to raise debt will be restrained to $5 billion.

Capital Structure Analysis

Historical Capital Structure

Before the merger between Grand Metropolitan and Guinness in 1997, the two firms were conservative in debt financing. Grand Metropolitan had a book D/E ratio of 1.64 (market D/E ratio of 3.14) while Guinness had a book D/E ratio of 1.03 (market D/E of 2.87), so both companies had been given good credit ratings of A and AA respectively.

When two firms are going to merge, the credit agency would normally place a credit watch as it was uncertain whether new firm would have different financial policy. To maintain a good credit rating, Diageo has implemented the risk management policy to actively manage the capital to keep the interest cover ratio within the band of five to eight times, in the sense would help Diageo maintain the credit rating of A+. Maintaining the credit rating of A+ will make their debt financing much easier and be able to access to short-term commercial paper at an attractive rate.

From the case Figure 1, we see how the firm maintaining their interest coverage ratio. The firm actively maintained the interest coverage ratio of the firm well within the range of 5-8. When there are signs that the interest coverage ratio would fall below or go above the range, the firm would maintain the ratio by re-levered the firm, including new debt issuance and share repurchase programs.

The book gearing ratios and the market gearing ratios give us a clear picture on how Diageo managed their right hand side of the balanced sheet differently compared to competitors. In fiscal year end of 2000, before Diageo was going to spin off Burger King and Pillsbury, we should consider Diageo as an integrated business which includes packaged goods, alcohol, beer, and fast foods. Therefore, the industry’s ratios should be compared to Diageo. In addition, Diageo has $30 billion market capitalization. Therefore firms that are similar in size would be relevant. The book gearing of Diageo is generally higher than the competitors in beer industry but lower than the package food industry average, and roughly at the same level as McDonalds and consumer goods industry average. Therefore, Diageo was considered in the middle of the entire industry average. We see that the market gearing of Diageo was 25%, which is slightly higher than both consumer goods industry average and packaged food industry average, therefore Diageo’s financial leverage was considered to be higher than industry average. Admittedly, market gearing depends on the market conditions and the result of evaluation may be subjective (as market prices are changing all the time and the ratio may be inconsistent over time).

Based on the book and market gearing ratios only, we see that Diageo fell within the industry average for book and market gearing, neither too conservative nor risk taking for managing the right hand side of the balanced sheet.

Trade-Off Theory

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Trade-Off Theory

The trade-off theory of capital structure is based on the idea of recapitalization costs. Firm will seek to maintain an optimal structure by balancing the benefits and costs of debt. The benefit mainly refers to interest tax shield, whereas the costs include expected financial distress costs such as bankruptcy cost and also costs associate with overinvestment and asset substitution problems. The implication of the trade-off theory is that firms have optimal capital structure and they adjust their leverage toward the optimum over time. In particular, a firm will try to maximize the value for its shareholders by equalizing the marginal cost of debt that results from the financial distress costs with the marginal benefit of debt that results from tax benefits. In addition, trade-off theory also suggests that large, mature companies with stable cash flows and limited opportunities for investments should have higher leverage ratios since they have lower financial distress costs. Moreover, these firms will be able to take advantage of the tax deductibility of debt. On the other hand, smaller companies with significant growth opportunities should make limited use of debt to preserve their continuing ability to undertake positive-NPV projects.

Application for Trade-Off Theory

We have constructed a model to estimate Diageo’s optimal capital structure. Diageo is planning to sell Pillsbury and spin off Burger King. So we have taken these two segments of the business out of the equation when accounting for sales. Sales are assumed to grow at 8% annually. We calculate EBIT over sales from the period of 1998 to 2000. We then take the average of that ratio and use it to forecast the future operating cost and margin. In addition, we have incorporated the fact that Diageo is integrating Guinness Brewing and there will be a £130 million cost reduction.

Assuming Pillsbury will be purchased by General Mills during the year of 2001, Diageo will be able to obtain $5.4 billion (£3.5 billion). However, according to exhibit 6 which shows Diageo’s liability structure, 3.2 billion pounds of debt are going to be mature within a year. Therefore, we believe most of the proceeds from selling Pillsbury will be required to meet these short term obligations Diageo is facing. Diageo’s Cash account will be increased by 300 million pounds and we are assuming Diageo will have constant cash balance. Diageo’s ability to raise short term debt through commercial papers will be extremely limited as their interest rate coverage is on the brink of falling below 5. Subsequently, Diageo’s short term debt will remain at an amount equal to 10% of long term debt after the repayment of short term obligations as some long term obligations will be classified as short term as it matures.

We took the average of days in accounts receivable, inventories and account payable of past 3 years. We have made our forecasts for these accounts presuming strategies for managing these accounts will not change. Even though in the Monte Carlo simulation depreciation is said to have a very minimal effect, however, we still adopted an amortization policy of 20 years straight line time horizon as we believe their machinery will not last forever. That is the reason why Diageo is spending 450 million pounds per year in capital expenditures to modernise it.

We are presented with Diageo’s current beta of 0.55, tax rate of 27%, debt to value ratio of 25% and debt to equity ratio of 33%. Using those information, we arrived at an unlevered beta of 0.44 and we relevered it to get a result of 0.52. We are using 5.83% as risk free rate because our debt are mostly denominated in the US and thus the US government interest rate is chosen to be the risk free in our model. Market risk premium is set to 5%. By applying the relevered beta into CAPM, we get a levered cost of equity of 8.4%. If we utilize the unlevered beta into CAPM, we will get unlevered cost of equity of 8%.

WACC is set as a forward looking function which incorporates the forward looking D/V and E/V ratio. The way we calculated for D/V is first by estimating interest expense by dividing EBIT by interest coverage ratio. Then we take interest expense and divided it by cost of debt, which is determined by rating of which is directly affected by interest coverage ratio. 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. Therefore, we can reasonably assume if Diageo decide to take on more debt and thus increasing these two ratios to similar position, Diageo should not be classified as distress nor downgraded as well. The additional 4% from 25% to 29% will translate into roughly $1 billion of additional debt for Diageo to take. As case suggests, rating agency will allow Diageo to take on a further 8 million without risk any downgrade. It seems to be a good opportunity as this extra debt will provide Diageo with a higher tax shield and not much foreseeable distress cost. Moreover, Diageo has a much higher price earnings ratio than the other two competitors. If Diageo were to take on more debt, the chance and rate of their growth should be somewhat greater than its competitors.

The trade – off theory is not the only consideration that Diageo used when deciding optimal capital structure. There are other important factors that Diageo may consider when deciding the capital structure. The most important one we believe is financial flexibility. After Diageo spin off Pillsbury and Burger King, it will be able to concentrate its business in beverage alcohol business. Growth for Diageo after “demerging” will mainly come from increase in market share or potential acquisitions, but the amount required for future acquisitions are virtually impossible to estimate with much certainty. However, the case have mentioned that in an “expansion scenario,” Diageo may spend as much as $6 to 8 billion for acquisition in the next three years. Therefore, Diageo should maintain its financial flexibility by preserving excess capacity in debt thus making it possible to finance future expansion and acquisition. Furthermore, flexibility tends to be associated with maintaining a target credit rating.

According to Diageo’s treasury team, they think that as A-rated borrower, they can probably raise additional debt of $8 billion. If Diageo were rated BBB, it may be able to raise $5 to 8 billion, and if they were rated BB they could raise less than $5 billion. Moreover, high rating will also help company to issue short-term commercial paper at attractive rates. However, these estimates are subjected to change over time. Therefore, if Diageo want to have sufficient funds for future acquisitions, it would be best if its rating remains at least at BBB to avoid insufficient fund for potential acquisitions. Hence it interest coverage ratio will be around 4.94. Even though A rating will provide company with benefit in borrowing short-term debt, but in the case of Diageo, the company will probability want to borrow long-term debt to avoid refinance in “bad times”. By locking rates over a long horizon, managers can effectively ensure their operations and strategic investments will not be disrupted by a spike in interest rates or otherwise difficult market conditions.

As indicate in case exhibit 6, Diageo has about £3.2 billion of short-term debt outstanding as in June 30, 2000 and about £5 billion debt is in US dollar ($7.57 billion dollars). Therefore, another factor that Diageo’s management will take into consideration for capital structure is whether to borrow in US dollar or in Sterling.

In the fiscal year of 2000, North America market accounts for approximately 47.5% of Diageo’s total revenue and 48.3% of operating profit. Diageo is likely to issue debt in US dollar since it provides natural hedge to foreign operations and at the same time keeping the source of the funds near the use of funds since most of Diageo’s acquisition target will be in North America.

It is fairly difficult to set a target debt to equity ratio to Diageo since we use market value of debt and equity to calculate the leverage ratio. The market value of debt and equity fluctuate daily, a strict target will require frequent rebalancing of outstanding debt and equity. There is transaction costs associated with issuing securities (both equity and debt). Therefore, management will also take into consideration of transaction cost when deciding capital structure, especially when firm decides to take on more leverage.

Monte Carlo Recommendation

The Monte Carlo structure basically exhibits the total present value of tax paid and distress cost. The optimal interest coverage ratio, which is EBIT to interest expense, should be set to 4.2 because this is where the firm can attain the minimum cost. In another word, the reason that is the most advantageous position is because the sum of tax paid and distress cost is the smallest among all other points. The downside is that Diageo will not be rated BBB instead of A due to the fall in interest coverage ratio from 5 to 4.2. The total debt is projected to be £9491 million.

According to treasury group’s recommend, the total capitalization will increase from £12,167 to £14,777 million, which represents a 21% increase going forward. Debt to equity ratio will proliferate from 1.3 to 1.8. Book gearing will escalate to 64% and market gearing to 34%.Allied Domecq has book and market gearing of 88% and 29% respectively. They are still able to maintain a rating of A-. Since the rating for Diageo is going to decrease regardless, a higher market gearing understandable as they are now able to pay less tax and not withstanding a huge distress cost.

Though the Monte Carlo model captured several important features of the dynamic capital structure, a number of features are still missing. In order to fully capture the dynamic nature of the capital structure, an ideal model has to be able to adjust to the optimal capital structure over time, which means the D/E ratio and interest coverage ratio should be reverting around the optimal level. The model developed by Diageo’s treasury group only incorporated half of this ideal feature: when the interest coverage ratio was too high, the company issued a special dividend to gear itself back to the targeted coverage range; however, there was no provision in the model for issuing equity to pay down debt when coverage fell, consequently no effort was taken to revert the coverage back to the target level. In addition, too many specifics of the financial distress costs were missing as the model only provided a simplification of the real world situation. For instance, court costs and agency costs were both hard to estimate and therefore were missing from the model.

Moreover, instead of assuming a likelihood of bankruptcy, the model attempted to estimate the costs of financial distress as a one-time permanent 20% reduction in firm value when the EBIT was less than the interest. The motivation was from the research paper “Designing Capital Structure to Create Shareholder Value” by T. Opler, M. Saron, and S. Titman, as they showed highly levered firms lost an additional 7% of market value during industry downturns relative to the average firm. However, there was no justification for using a 20% reduction.

In addition, the model did not consider the affect that company will be going through major changes in the next 2-3 years, such as acquisition of potential beverage companies and selling off Burger King. These deals would probably result a substantial change on Diageo’s capital structure.

Lastly, Monte Carlo model was not able to capture the dynamics of the market condition over time. For the model to be more efficient, it has to be adjusted constantly to reflect the current situation of the market condition.

Pillsbury and Burger King

Strategically, if a company is running a set of businesses, in order to achieve the optimal profit margin it would either choose to go full-scale or to be a niche. In Diageo’s case, food business is as a middle segment of the pack, therefore demerger Pillsbury and Burger King would allow Diageo to focus on beverage alcohol business. Concentrated business would make it more feasible for growth through innovation around unrivalled portfolio of brands and providing an improved base for later sustained profitable top line growth.

Pillsbury, which contributed a quarter of Diageo’s operating profits, was too small to prosper on its own and at the same time its core business Old EI Paso Mexican was under a fierce competition in American market. Therefore by selling Pillsbury to its rival General Mills, the Pillsbury could have greater potential for cost synergies. Since Diageo still owns 33% of the new General Mills/Pillsbury business, the cost synergies would also benefit Diageo as a shareholder.

Burger King, which resembles the smallest part of operating profit, is also the fastest-growing segment of Diageo which might enjoy a higher rating than Diageo itself since it is in the fast food industry. Therefore from a long term perspective, the demerger of Pillsbury and Burger King would provide more capital for further expansion.

There was a remarkable performance of the core business in Diageo: the alcoholic beverages-Spirits and Wine segment and Guinness Brewing segment both revealed to experience increase in the market share. The profits attained from those two segments accounted for half of Diageo’s operating profits during 2000.

In addition, concentrating solely on its core business would allow Diageo to enjoy marketing synergies, production and purchasing efficiencies. These benefits could arise from cost saving in manufacturing, procurement and supply; the savings could also pass through distribution system and have enhanced ability to reach consumers. As the case indicates, Diageo was in the process of integrating its two core businesses, which might result in cost reductions of ₤130 million annually. Moreover, by concentrating on beverage alcohol business, Diageo is able to capture more cost synergies when acquiring rival firms.

Lastly, concentration also reduced the chance for the sub-companies under Diageo’s alcohol beverage category to become the potential acquisition targets of its rival companies.