Diageo was created when Grand Metropolitan, plc and Guiness, plc merged in 1997. While the Diageo name is not well known to consumers, its brands are among the most famous including Guinness, Smirnoff, Johnnie Walker and Cuervo. The company recently decided to focus on a strategy to grow through its spirits, wine and beer businesses and divest of its Pillsbury and Burger King subsidiaries. This case study will focus on the proposed capital structure decisions of Diageo.
2) Is Diageo’s current capital structure appropriate to its new business? It believes that it has traditionally had a conservative debt policy. If so, is that policy still appropriate? Has Diageo’s capital structure been as conservative as it believes? (What interest rate coverage ratio has it been targeting? How does it look relative to its competitors?) Diageo’s capital structure has not been as conservative as it believes. Although their capital structure in FY 2000 has been as conservative as it has targeted, it is less conservative compared to other companies in related industries. The interest rate coverage ratio that it has been targeting is between 5 and 8 x and they currently have a ratio of 5 (Exhibit 4). This ratio is low compared to the average Alcohol (8), Beer (10), and Beverage (13) segments. Below is Diageo’s current interest coverage ratio compared to its competitors:
3) Why pursue a conservative debt policy?
Having a conservative debt policy increased the credit worthiness of the firm. Because the firm believes that the interest coverage ratio is a critical factor for credit rating agencies, they attempted to keep this ratio very high. Also, by having a higher credit rating they are able to access short term commercial paper borrowings at better rates. This type of short term borrowing makes up 47% of Diageo’s portfolio. By not having a strong credit rating they would not be able to lock in the low rates which would impact their business significantly.
4) What recommendation is the firm’s trade-off model for Diageo’s future capital structure? In order to maintain its credit rating, Diageo’s Treasury team recommends an interest coverage of 5x to 8x, but the simulation-based model calculated an optimal interest coverage. Figure 2 shows minimal cost corresponding with an interest coverage of approximately 4.2. Shown in the gray bars, the cost of taxes paid decreases as EBIT/Interest increases. A decrease in interest due to debt lessens the tax shield benefits available to the firm, so the cost of taxes decreases as we move along the x-axis of Figure 2. However, as the firm increases its debt, its potential cost of financial distress also increases. Considering variables such as: Local EBIT, Interest Rates, Foreign Exchange Rates and Market Conditions, the model predicts a minimum cost at a 4.2 interest coverage.
5) Does the model capture all important risks faced by Diageo?
The model does not fully explore the risks associated with doing business across a vast international market. There is risk due to political factors that the Diageo team did not take into account. Also, the model assumes a constant tax rate, and there is no guarantee that Diageo will not experience fluctuations. These trials figure a 20% reduction in value of the firm as a result of financial distress, while Richard Passov’s article How Much Cash Does Your Company Need? calls out a 30% reduction in value for Branded Consumer Goods. If that estimate is accurate, Diageo should adopt a more conservative capital structure to compensate.