I. Executive Summary
Diageo, one of the world’s leading consumer goods companies, was formed from the merger of GrandMet and Guinness. In 2000, the company announced its intention to sell its packaged food subsidiary, Pillsbury, and 20% of its Burger King subsidiary. Because of the restructuring opportunity, the company wanted to rethink its financing mix.
In this case, the tradeoff between the costs and benefits of different leverage policies will be discussed. A simulation model was created by Diageo’s director of Finance and Capital Markets, Ian Simpson, and Adrian Williams, the firm’s Treasury Research Manager, to understand the tax benefits of higher gearing and the cost of financial ...view middle of the document...
7. Diageo announced its intention to sell its packaged food subsidiary, Pillsbury, and 20% of its Burger King subsidiary, and focus on the beverage alcohol industry in the following days.
8. General Mills would pay Diageo $5.1 million in cash plus 141 million shares of General Mills stock if Diageo sold the Pillsbury to them.
9. The book value of equity accounted for 42% of the total assets of the average U.K. firms, which are considered to be more conservative than firms in other nations.
10. Strong debt rating afforded considerable benefits.
11. Acquisition could be integrated into its system, allowing Diageo to enjoy certain efficiencies and synergies.
1. Following the current capital structure, at which the interest coverage is from 5 to 8.
2. Taking more debt, decreasing the interest coverage.
3. Taking less debt, increasing the interest coverage.
i. How did Diageo historically manage its capital structure?
| GrandMetCY 97 PF | GuinnessCY 97 PF | FY 97 PF | FY 98 | FY 99 | FY 00 |
Equity/ Asset | 38% | 49% | 42% | 30% | 28% | 33% |
As it mentioned in the case, an equity-asset ratio of 42% was considered to be conservative, and most companies in highly developed nations other than UK had an equity-asset ratio from 28% to 40%.
In that case, Diageo had pretty safe financial policies since its equity-asset ratio was more than 28% from 1997 to 2000. Prior to the merger, both of GrandMet and Guinness had quite conservative capital structure. Guinness had an equity-asset ratio of 49%, which was reflected in the AA rating of Guinness’ bond.
After the merger, Diageo’s management maintained similar financial policies adopted by the two previous companies. From 1997 to 2000, the interest coverage of Diageo was always more than 5, which helped the company gain an A+ rating.
ii. Tradeoff between tax benefits and cost of financial distress ― Simpson and Williams’ simulation model
As I discussed in the American Home Product case, the cost of financial distress increases, and the tax expenses decreases along with the increase of debt. This theory was explained even better in this case.
Low debt could help Diageo get considerable benefits. They can rise financing more readily, and pay lower promised yields. They can access short term commercial paper borrowings at more attractive rates. However, if the debt ratio is relative high, the company has to face various costs, such as direct and indirect cost of financial distress.
However, because the interest of debt could shield part of earnings from taxes and strengthen management’s incentive to increase sales. Some financial analysts hold the view that companies should take appropriate debt. The tax expense could be decreased along with the increase of debt.
When we put the two curves together, we can get the relationship between the debt ratio and the total cost of financial distress and tax expenses. We can see there is a...