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Diageo Plc: Capital Structure Case

Essay by   •  April 18, 2017  •  Case Study  •  2,033 Words (9 Pages)  •  3,655 Views

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Case Study: Diageo PLC: Capital Structure Case

Diageo case paper     Thinking of divesting some of their decisions, looking at their capital structure and if it makes sense and so on.

What line of company is Diageo? Food. Formed in 1997, created the 7th largest food and drink company, sales in 140 countries, brands such as:

 Bacardi, Guinness, Smirnoff in drinks and in food, brands such as Burger King, Pillsbury.

But want to sell 20% of Burger King and Pillsbury and the rest to follow. Reason for this is they want to have a stronger focus in one particular area, but they won’t be as diversified.

 Is there a downside to being diversified though? Companies normally want to be diversified, happened a lot in the 80s but in 90s, focus shifted back to the costs associated with diversification.

3 types of mergers: (Ruchi mentioned this as important in lecture)

Horizontal merger  same sector

Vertical merger  mergers between suppliers and buyers

Conglomerate unrelated businesses, often result in synergies that are not as high as expected, savings which aren’t as high as expected because of the total unrelated fields.  

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Introduce explanations for capital structure/different structure of capital.

Static trade-off 

Balancing the benefits if debt with the cost of debt. Different types of companies can support more debt.

Debt ratio that the manager have in mind and are working towards.

Pecking order → if the company has a deficit,  they look for external financing but this send out a signal the company is in trouble. E.g. selling off stocks show they may be overvalued and company is selling them off before they are revalued.

Market Timing →Managers issue equity when they believe it is overvalued. Is this the same as the pecking order? Difference is a bit more subtle with market timing the market is not pricing equity correctly and therefore unrelated to the market timing.

Agency Costs→ could fall under static trade-off. Choice of debt to minimize agency conflict.

Market for company control→ Company can make itself look less attractive by buying more debt.

→ Tangible assets, profitability, R&D, Assets

Pecking Order

→No optimal debt ratio, debt defaulting

Market Timing

→ Market to book Ratio, if this is high, may create an incentive to sell shares.

Target Debt Ratio:

If it is static trade-off, there may be a target debt ratio, if a company strays from this,

Adjustment to optimal

 Costs 

Immediate adjustments can be made if costs are too low.

If costs are too high, at other extreme, how long will it take them to get back to their optimal target ratio.

Within about 3 years, should be back to optimal debt ratio, if adjustments made correctly.

Define market debt ration (MDR) as [pic 1]

Book value does not capture the growth opportunities of the company.

Whether you use market ratios or book ratios, similar results will occur.

Questions to consider while reading Diageo Case:

  1. How has Diageo historically managed its capital structure?

Diageo tends to have to have more conservative financial policies than firms in other nations. Research showed that the book value of equity accounted for 42% of the total assets of the average UK firms (excluding financial service firms), as compared with 28% to 40% in other highly developed nations. Both Guinness and Grand Metropolitan used reasonably little debt to finance themselves prior to the creation of Diageo. This policy choice was reflected in the relatively high ratings on the bonds of the two firms, AA and A, respectively. Ratings agencies, like Standard and Poor’s and Moody’s, assigned ratings to bonds to reflect the company’s ability to make promised interest and principle payments on its debt. The enlarged group’s policy is to manage actively the capital structure so as to keep the interest cover ratio, in normal circumstances, within a band of five to eight times. What Diageo pull away with from maintaining this capital structure framework is that they have a greater ability to exploit market opportunity since they have access to a cheap rate of upon which to borrowing.

High rating was the ability to access short-term commercial paper borrowings at attractive rates. Short-term interest rate available through the commercial paper market were up to 25 basis points below the LIBOR, The interest rate that A rated companies paid on 5-year bonds was typically LIBOR + 40 basis points, or .65% higher than the CP rates. Lower rated firms found it difficult to raise money in the commercial paper market, as this was an unsecured form of borrowing. Furthermore, the major holders of commercial paper (money market funds) were prohibited by regulation in holding more than 5% of their portfolios in low-rated short-term funds. Approximately 47% of Diageo’s debt, about 3.2 billion pounds, was issued as short-term commercial paper with maturities of 6 months to one year. If Diageo’s long-term debt were to be rated BBB, its ability to raise commercial paper might be severely limited.. Problem with borrowing from short-term market, lenders can start demanding higher rates). Banks used to borrow on short term and lend on long term, this high risky, total mismatch of duration. For Diageo, this may not be too much of a concern as they have a lot of short term accounts receivables. Loan can be paid off as money flows in regularly. Want to match assets and liabilities when borrowing.

        

  1. What is the static tradeoff theory? How would you apply it to Diageo’s business prior to the sale of Pillsbury and spinoff of Burger King

Balancing the benefits if debt with the cost of debt. The trade-off theory of capital structure is the idea that a company chooses how much debt finance and how much equity finance to use by balancing the costs and benefits. ... Often agency costs are also included in the balance. Different types of companies can support more debt. Debt ratio that the manager has in mind and is working towards. A company with a lot of tangible assets. If static theory is what is driving management decisions, we would expect more fixed/tangible assets to carry more debt as they can support this more debt. Second, company with a lot of growth potential for growth is similar to a company with lots of tangible assets. Or a company with a lot of research and development. A company with a lot of potential but maybe not the assets behind it. Thirdly tax reasons. Tax yields can be taken advantage of by companies who have a low level of profitability. Benefits of the tax yield are limited as their profits are not too high anyway. Company with huge levels of profits may take on debt to reduce their tax bill. For Diageo, this may not be too much of a concern as they have a lot of short term accounts receivables. Loan can be paid off as money flows in regularly. Want to match assets and liabilities when borrowing. Benefits of strong debt rating: You move to different yield curve, the more or less debt you have.

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