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.
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