Diageo Case Write Up

Diageo Plc Achint Malhotra (1449862) Amandeep Arora (1441665) Pikun Pattnaik (1437171)

This report captures various capital structure related issues faced by our client - Diageo Plc. It outlines existing capital structure practices at Diageo followed by our recommendations on the company’s future capital structure

We, on behalf of AAP Consulting, have the honor to work with our client Diageo Plc in providing financing, capital structure, and risk advisory. Our firm has more than 10 years of experience in financial management, M&A advisory, capital restructuring and risk consulting helping our clients in making better and informed decisions in their businesses.

Our Client Diageo Plc. was formed in 1997 from the merger of Grand Metropolitan plc and Guinness plc. It was the seventh largest food and beverages company with a market capitalization of ~ £24 billion, annual sales of ~ £ 13 billion, and operations in more than 140 countries. The firm was organized in four segments- Spirits and Wine business, Guinness Brewing, Pillsbury subsidiary (packaged foods), Burger King subsidiary (fast-foods). In September 2000, Paul Walsh became the Group Chief Executive of Diageo and started to consolidate Diageo’s operations to be primarily focused on the beverage alcohol business, with the growth coming from organic growth or potential acquisitions.

Historical Capital Structure Up until 2000, capital structure policy of our client Diageo was conservative maintaining quite high book equity to assets ratio inherited from its predecessors. Both Guinness and Grand Metropolitan maintained very conservative capital structure to maintain a high level of credit worthiness. Both used little debt for financing and as a result the rating agencies rated both these companies highly. The bonds of the two firms were rated AA and A. Upon the merger, Diageo maintained similar financing policies as the merged companies. Our client maintained healthy interest coverage ratio- within a band of five to eight times. The new merged entity was rated A+ by the rating agencies. In addition, the firm kept EBITDA/Total debt at ~3035%. We believe that company didn’t fully utilize its debt capacity, leaving some amount of money on the table because of under-leveraging. (Exhibit 1 shows the historical interest coverage ratio of the firm) With relative low volatility in ROA, strong credit rating and healthy financial ratios meant that our client could increase its gearing without substantial increase in risks. Low level of equity’s beta also supports our viewpoint that earnings weren’t highly pro-cyclical. Our client hence was able seek opportunities to access short-term commercial papers as a source of borrowing at attractive rates. Approximately, 47% of our client’s debt was issued in the form of short-term commercial papers, which amounted to ~ £ 3.2 billion. Its ability to raise commercial papers would have been highly limited if it had a rating of BBB.

Diageo vis-à-vis Static Trade-off theory The static trade off theory attempts to explain the optimal capital structure in terms of the balancing act between the benefits of debt (tax shield from interest deduction) and the disadvantage of debt (from the increased expected bankruptcy costs). Firms try to balance the costs of financial distress against the tax benefits of debt (modeled as tax shields by MM theory) while making capital structure decisions on how much debt to use for funding various investments. Costs of financial distress include both bankruptcy costs (poor cash flows leading to bankruptcy in a highly levered position) and non-bankruptcy costs (increased cost of capital, ability to advantageously use commercial paper, supplier demanding stricter payment terms etc) If we apply this model to our client Diageo’s business prior to the sale of Pillsbury and spin-off of Burger King, in a historic structure based in lowers debt ratios we can see the optimal debt ratio can be higher than historical debt ratio. We suggest that our client should borrow up to the point where: Marginal benefits of the tax shield = Marginal cost of financial distress When this happen the debt increases the firm value by reducing the corporate tax bill. In case of our client, the major issue is the measure of bankruptcy costs and the uncertainty of operating income. The uncertain of operating income can be resolve by observe the historical cash-flows as the company observed considerably stable cash flows in the alcohol business. So, if we apply the tradeoff theory to our client, we can conclude that they are in the left of optimal debt ratio so they can have a bigger debt ratio. Our client has maintained high credit ratings and high interest coverage ratios. It could maximize its tax shield by increasing its debt levels and using its cash positions to aggressively bid for targets like Seagram to grow its beverage alcohol business.

Our Recommendations The Monte Carlo model (Exhibit 4) undertook by the Corporate Finance and the Treasury team presented a couple of significant trends and insights for Diageo. After careful consideration of the input factors and results generated by the model, we at AAP Consulting believe that our client should continue to make use of more leverage in terms of its expansion plans. This recommendation comes in the light of Diageo’s ability and willingness to repay its debt obligations along with availability of cheaper sources of financing. Diageo’s beverage business enjoys continuous and stable cash flows, which in turn acts as a hedge in terms of the repayment of interest and principal obligations of the debt. This is complemented by the strong historical fundamental performance of the firm. The firm enjoyed strong financial ratios like Interest Coverage ratio and strong credit ratings from the rating agencies. The firm’s profitability as shown in Exhibit 2, highlights better profitability and less volatility as compared to other industries. The average ROA for beverages was about 17.7% with a volatility of 1.9%. These financials are pretty healthier than the competition. Under such a situation, it makes perfect sense for our client Diageo to make the best utilization of leverage. Considering our client’s ability to raise financing through cheaper sources, it will end up paying lesser finance costs and would even get the benefits of tax shields. One of the biggest shortcomings of this model is that it ignores the potential benefits of leverage in terms of increase in assets through acquisitions. This models accounts for only the tradeoff between tax shields and financial distress. Diageo estimates it ROA to be 17.7% without the packaged (Pillsbury) and fast food (Burger King) segments. With a “midrange” estimate of $2.5 billion in acquisitions (as per the case and assuming it’s done with 100% leverage) over the next five years, our client can increase its sales revenue and EBITDA at a corresponding rate. However, one might argue that interest payments thus cost of debt would also increase. This argument is reasonable except for the fact that the return of equity (ROE) of 22.3% is higher than the cost of debt of 22% even with a BBB rating (exhibit 5). Moreover, our client can address any perceived extra costs of financial distress by playing with the £ 1 billion advertising budget. Hence, I believe our client Diageo can confidently pursue its acquisition strategies by increasing its leverage without having a financial distress. We also recommend our client to maintain Interest Coverage Ratio of 3.5 to 5 times. With these EBIT/Interest ratios, our client will be able to minimize the total costs of taxes and financial distress. This will represent the most optimal combination of Interest Coverage ratio (Exhibit 3). There are some other shortcomings of the existing model created by our client in-house. There could be some significant risk factors that the firm did not capture. The most important inputs considered were based on historical results. The focus remained around fluctuations in sales and exchange rates. Since, there have been a couple of changes after the merger of the two entities to form Diageo, there would a lot of changes affecting future projections. One significant area would be taking into account the value of synergies and the effect of dilution/accretion of the Earnings per share on the new entity. In addition, since our client would lay a lot of emphasis of organic growth though major capital expenditures, we recommend taking into consideration the effect of

depreciation and capitalizing the costs of the future expansion plans and their effect on our client’s cash flows and profitability. Furthermore, in a situation of financial distress, our client could resort to equity financing rather than facing a 20% reduction in the value of the firm. This existing assumption is hard to substantiate. Despite the missing risk factors, we continue with our recommendation to maintain strong interest coverage ratios and continue expansion efforts with more leverage. However, we also recommend taking into consideration the future projections and its impact on cash flows. We also recommend considering various qualitative factors like integration issues and change in leadership post merger. The end objective is to increase the firm profitability and increase shareholder value.

Appendices Exhibit 1

Diageo Group Interest Coverage, 1997 - 2000

Exhibit 2 Industry returns on assets (EBIDTA/assets), with Diageo mix of businesses

Median industry returns on assets, 1950 - 1999

Exhibit 3

Output chart from model

Exhibit 4

Simplified flowchart of Monte Carlo Simulation

Exhibit 5

Selected data on bond market for 5 years notes, October 31, 2000