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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
companys 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 Diageos 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 didnt 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 equitys beta also
supports our viewpoint that earnings werent 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 clients 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--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 Diageos 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
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 Diageos ability and willingness to repay its debt obligations
along with availability of cheaper sources of financing.
Diageos 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 firms
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 clients 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 its 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 clients
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.

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