Diageo Plc

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Prior to sale off Pillsbury and spinoff of Burger King, Diageo maintain a conservative capital structure, which maintain a high debt rating and low leverage to take the benefit of financing capacity and low interest of commercial paper. As Diageo’s financial distress would be less because of reputation, it could reconsider increase its leverage to take more advantages of tax shield.

In conclusion, the firm should increase its leverage until it reaches the point of value maximization and thus an optimal target financial debt ratio, when the tax savings resulting from increasing leverage are perfectly offset by the increased probability of incurring costs of financial distress and net agency cost.

4. Sales of Pillsbury and Burger King

The trigger of the sales of Pillsbury Burger King should be the company’s below-the-average stock price. Since mid-1999, Diageo’s stock price had trailed the rest of the market, this lag grew to a significant level by early 2000 which was when the decision to streamline the business was made. When facing such a sharp decline in the firm’s value, the corporate executives will be forced to respond and try to turn around the situation. So, Diageo decided to sell its Pillsbury division, and float 20% of Burger King so that the company does not trigger a significant tax charge. The remaining 80% will be completed after 2002 for tax deduction reason. The motivation to sell Pillsbury and to spin off Burger King is mainly to become more focused on the beverage alcohol side of the business, and we can conclude it in the following three aspects: strategy, operating and financial consideration.

Strategy consideration:

- Diageo’s new strategy was to focus on beverage alcohol industry to realize growth through innovation and improved base for sustained profitability.

Operational consideration:

- Increased sales of existing products or product extensions.

- Increased bargain power of industry to improve premium brands and pricing.

Financial consideration:

- Diageo would receive $5.1 billion cash and 141 million newly issued shares of General Mills stock which were worth around $5.4 billion. Those funds could support the growth need for Diageo. Growth could result from organic growth or potential acquisitions, both of which need large amount of capital to realize.

-Organic growth expenditure demands: On-going capital expenditures projected to require about £400-500 million per year for next five years.

-Acquisition expenditure demands

scenario

expenditure(million)

expansion scenario

$6-8

Mid-range

$2.50

minimalist

little

• Enjoy certain efficiency and synergies including cost savings in manufacturing, procurement and supply or distribution system.

Value-added function

After the sale, the remaining divisions have a relatively high operational margin, and high growth rate in sales, which could bring more net operating income to the company.

Value-added function could be realized through continued growth, increased turnover, reduced costs, tax saving and potential improved capital structure.

- Continued growth

Through selling Pillsbury and spinning off Burger King Diageo could realize its strategy of focusing on beverage alcohol and continued growth from organic growth and potential acquisition. The improve growth of the company could increase the value of entity.

- Increased turnover and reduced costs

Increased sales might be realized through organic growth result in increased turnover. At the same time, benefits from potential acquisitions might lead to synergies and improved efficiency which could save costs in many aspects. Increased turnover and reduced costs could rise operating profits and might add more reserve and dividends to equity value of the company and shareholder’s wealth, both of which could add the value for shareholders.

- Tax savings

Enjoy little tax charge through float 20% of Burger King and no further tax charge through later spin-off of Burger King.

- Potential improved capital structure

Through restructure, Diageo could reconsideration its financial policy and capital structure and adjust to the optimal capital structure to maximize the value of the entity.

5. Factors involved in simulation model and further adjustments in the model

The optimal capital structure for Diageo was one that minimize the PV of financial distress and maximize the PV of the tax-savings. In another word, when PV of tax-shield is counterbalanced by increases in PV of financial distress costs. According to simulation-based model, the total PV of taxes cost of financial distress minimized at interest cover ratio around 4.2. As Diageo now kept the interest cover range of 5.0 to 8.0, it could considerate lower its interest rate and increase gearing to take advantage of more benefits from tax shield, which would be larger than the costs of financial distress at this level of gearing.

However, this simulation-based model was a relatively static model and did not capture many risk factors that Diageo would meet.

- Interest rate: US interest rate and fixed credit spread.

Interest rates are all linked to US interest rate. However, in Diageo, dollar liability account for nearly 68% of total liability while euro and sterling account for 30%. it might be more accurate to calculate interest according to their currency interest rates instead of using dollar interest rate. Besides credit spread would change with the changes of rating. It would be less rational to assume fixed credit spread. Instead Diageo should adjust interest rates while taking into account of differences of both currency and credit spread. Credit spread for different rating