Diageo Plc: Capital Structure Case

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Reason for this is they want to have a stronger focus in one particular area, but they won’t be as diversified. Is there a downside to being diversified though? Companies normally want to be diversified, happened a lot in the 80s but in 90s, focus shifted back to the costs associated with diversification. Diageo is the kind of company who is not too worried about A-symmetry information. The line of business they are in is fairly stable, cash flow probably not coming in with a lag, orders probably paid right away. They probably can afford to take on more debt, notwithstanding the conservative stand that they have.

Static trade off model predicts that each firm adjusts gradually toward an optimal debt ratio. They can use this focus on a single sector to mitigate cost and in doing so maintain the ideal debt ratio and in doing so the AA rating. Dumping Burger King and Pillsburg allows them grow profits organically in the beverage sector without have too onerous an effect on the debt ratio.

- Why is Diageo selling Pillsbury and spinning off Burger King? How might value be created through these transactions?]

With the selling of Pillsbury and spinning off Burger King, Diageo could concentrate solely on the beverage alcohol business. Continued growth could come from organic growth or from potential acquisitions. “ Organic growth” might involve increased sales of existing products or product extensions, such as Smirnoff Ice,a blend of Vodka and lemon juice or a new bottled version of Guinness. On-going capital expenditure to support organic growth as well as to modernize existing production facilities was projected to require about £400- 500 million per year for the next five years.

Growth could also come from acquisitions but the amount that Diageo might need was virtually impossible to estimate with much certainty. It was unclear which firms Diageo might be able to acquire, how hotly contested the bidding might become. Diageo’s major rivals in the alcoholic beverage industry, such as Bacardi, Allied domecq, Seagrams and Pernod Ricard were not only potential rival bidders for firms and brands, but potential acquisition targets themselves in the consolidating beverage alcohol business. For example Seagrams beverage unit was up for sale in autumn of 2000 and analysts guessed it might fetch $7 to billion. Diageo was working on a joint bid for Seagrams with Pernod Ricard, which might commit Diageo to spend $3 to 5 billion. Similiar private firms and individual brands were also considered potential acquisition candidates at the right price.

This distribution of profitability, especially for the beverage alcohol business, would give them some information on the future distribution of profitability. In general, all of Diageo’s business, including the beverage alcohol business which it would retain, had relatively stable cash flows, which had allowed Diageo to take on a higher level of debt than other companies.

Interested in looking at Figure 2: Simulations which have been conducted which show the 2 things that we would be concerned about, what would affect market value? Tax Shield....... v.......... Financial distress costs (they have used 20%, is this reasonable for a company like Diageo? If financial distress does occur, they have a high level of tangible assets, should be able to convert these quickly to cover the costs. People aren’t concerned when they buy their products if the company is in trouble and may be closing in the future, not the case with AerLingus etc. worried that if they close down, flight will be cancelled or Budget Travel etc. ) Modelled this, tracked if the inflow of earnings and if at different interest covers at different levels of interest cover (high means they have less borrowing and little repayments). Looked at the simulations and looked for optimal points at where benefits at debt and disadvantages of debt meet

- Based on the results of the model, what recommendations would you make for Diageo’s Future capital Structure? Does the model capture all of the important risk factors faced by Diageo? How might you adjust the recommendation from the model to adjust for any missing risk factors?

What goes into the simulation? How did they generate this simulation?

Basically, using the Monte-Carlo simulations to identify possible pathways and what might earning be 1 year from today, and if debt policy remained the same, what are the taxes we would have to pay and what are the financial distress costs? Identify the earnings cover ratio at different earnings. Take different possible earnings figures for next year. Calculate the taxes paid. Sometimes the taxes paid will be less than the interest paid and this means the company is in financial distress (i.e. lose 20% of value). In this case, they are looking at the taxes paid. At low levels of debt, the company pays higher taxes. At very high levels of tax being paid, there is very little chance of failing and therefore very low levels of cost of financial distress. But at higher levels of debt, this cost is more. Based on their own simulations, they can afford to take on more levels of debt without affecting the company too much.