Diageo Essay

1177 Words Mar 28th, 2013 5 Pages
Diageo Case

1. How has Diageo historically managed its capital structure?
Diageo sought to maintain the low-debt (conservative) financial policies of the Guinness and Grand Met with goals to keep * its interest coverage ratio (EBITDA / Interest Payments) between 5 and 8 and * its EBITDA / Total Debt around 30-35%
Although not quite as conservative as other UK firms (with Equity/Assets ratios of 42%), it was successful in achieving these goals and retaining a credit rating of A+ (a rough average of Guinness’ AA and Grand Met’s A ratings) by re-levering the firm via * issuance of debt to repurchase and retire shares in fiscal years 1998 and then again in 1999 * and ensuring that cost of capital was managed down at
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In general, the greater leverage Diageo uses in its capital structure, the greater the interest payments and higher probabilities for distress; but this also corresponds to greater tax shields that can be realized. As variable inputs, the model identifies three primary risks: the ROA (which relates to operating cash flow), the currency exchange rate, and interest rates (which determine interest expense). Based on statistical results of the model as is, we recommend that Diageo continue to maintain their interest coverage ratio of 5 to 8; as concluded in the simulations, the likelihood of financial distress is low within this range. This reflects the stability of Diageo’s operating cash-flow and ability to secure good credit ratings / interest, while also allowing Diageo to realize 0.5 to 1.0 B (in PV terms) of tax savings through leverage.
One risk that is not considered is the lost opportunity cost for Diageo to utilize additional leverage for acquisitions of new companies or reinvestment into their core business. While the model focuses primarily on the tradeoff between tax shield vs. financial distress, it does not directly account for potential benefits to shareholder value through increases in Diageo’s asset base. Diageo estimates its ROA, defined as EBITDA / Asset, at 17.7%. As part of Diageo’s growth strategy for the next 5 years, the firm calculates “midrange” of $2.5B in acquisitions over the next 5 years. Assuming

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