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. 942.
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 dollars3).
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.
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