Diageo Plc - Case Report

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Though we cannot accurately quantity the cost of financial distress, we could reasonably analyze the probability of financial distress and associated cost based on the company financial and operating information. First, the firm has a credit rating of A+ which allows the firm to borrow up to $8 billion within a year without rating downgrades. Secondly, the interest coverage ratio of 5 – 8 times indicates that the firm has adequate debt repaying capacity. Thirdly, the firm has been stably generating cash flows in the past few years which allows a higher level of debt. Lastly, the firm has large fixed asset portion in its total asset which can be liquidated in case of financial distress. From these four factors, we can reasonably conclude that Diageo currently has very low risk of financial distress. Therefore, given its low debt level and low tax shield utilization, Diageo can be more aggressive on its leverage policy to issue additional debt to fund its on-going capital expenditure and potential acquisition opportunity.

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Sales of Pillsbury and Spinoff of Burger King

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Why Divesting the Two Subsidiaries

Due to the unsatisfying stock performance of Diageo post the merger, in September 2000, the group CEO decides on a new strategy to concentrate on and grow the beverage alcohol business, the biggest and fastest growing segment which contributes 41.88% to the total revenue and 50.60% to the total operating profit. The management hopes to consolidate its leading position in alcohol beverage business by organic growth and potential acquisitions. Obviously, Pillsbury and Burger King do not fit into the new business strategy. Since Diageo was an active seller of brands that did not fit into its growth strategy, it is most sensible to divest the two business segments.

Pillsbury is the least profitable segment of Diageo in the past years. To support the new strategy, Diageo therefore decides to sell the division with upfront cash of $5.1 billion and 33% of the new General Mills/Pillsbury business. Though Burger King is a relatively more profitable segment, it still needs to be spun-off to totally focus on beverage segment. Since Diageo has a focus on shareholder value, in view of the tax regulations, it adopts the strategy of two-step spinoff, by floating 20% in 2001 and the remaining 80% after 2002 to minimize the tax impact to Diageo and its current shareholders.

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Value-creation through Divesting

Divesting of the two subsidiaries could create value to the firm and its shareholder in many ways. First of all, the two subsidiaries are incompatible with its goal of growing beverage business. Divesting them allows Diageo to focus on the core business without worrying about the operating and funding decision of unrelated business. Since Diageo seeks to drive alcohol beverage business through organic growth and from potential acquisition, both of which requires a large capital expenditure as estimates provided by the treasury team, Diageo could inject all capital available into this segment without capital requirement for other segments.

Secondly, divesting the subsidiaries could bring upfront cash proceeds for Diageo to fund other investment opportunities. For example, selling of Pillsbury bring in cash of $5.1 billon which could be used to partially fund the acquisition of Seagram’s. With the spinoff of Burger King, it would save up a significant tax expense, which can be used to cover the on-going capital expenditures and to satisfy the capital need for business integration, which can further allow Diageo to enjoy certain efficiencies and synergies.

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Monte Carlo Simulation Model

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Model Output and Recommendation

Given the complications of multiple variables and difficulty of estimating probability for each variable when analyzing the cost and benefits of different gearing level, the treasury team resorts to the Monte Carlo simulation technique to tackle the problem. The simulation model is based on the static trade off theory to calculate the present value of total futures tax and cost of financial distress across a set of gearing polices. Running this model for as many as 10,000 times would generate a more precise distribution of the present value, and therefore an optimal capital structure can be determined at the point where the PV of total tax expense and distress cost is lowest.

Based on the simulation output in Exhibit 1, the present value of taxes paid and distress cost is minimized when interest coverage ratio is around 4.2. As we know, Diageo currently has a policy of maintaining interest coverage ratio within 5 to 8 times, this means that Diageo still has a large room to lift up the debt level to further exploit the tax shields benefits without impairing the firm value because of financial distress costs. However, given the potential large capital needs for organic growth (cost $400 – 500 million per year for next five years) and acquisition opportunities (cost about $2.5 billion over five years), it is necessary to keep enough financial flexibility for Diageo to raise funds whenever necessary. Therefore, we would recommend a more conservative EBIT/Interest ratio than the model output. We think 5 times interest coverage ratio would be suitable to balance the debt benefit/cost while allowing certain level of financial flexibility.

Exhibit 1 Output Chart from Model

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Missing Risk Factors and Limitations

The model has included important factors such as local EBIT, interest rate, foreign exchange rate and market correlations. But because of a number of assumptions that the treasury team made, the model is still vulnerable to some risk factors.

First, most important inputs in the model were based on historical data. It does not include possibility for new debt and major investment, which is likely to be the case. As Diageo tries to achieve the new strategy, it will seize any good opportunity for acquisitions to maintain the leader position in this industry. Significant changes usually occur after acquisition or restructuring, therefore input should be modeled based on any possible actions affecting future projections.

Secondly, the model takes into account the interest costs at the