Diageo was conglomerate involved in food and beverage industry in 1997. Initially founded by a merger between Grand Metropolitan and Guinness, the company went to become a significant player in the industry. For a number of reasons (low borrowing cost, investor confidence), Diageo opted to keep a conservative capital structure with low levels of debt. Three primary factors governed the capital structure policies of Diageo. They included Interest coverage ratios, EBIT to debt ratio and a target rating of A+. The simulation model constructed by the treasury group of Diageo clearly reflected that the company was underleveraged and could increase its market value by taking on more debt and using it to finance internal growth and acquisitions. Although, the simulation provided an in depth analysis for decision making; it lacked analysis on the operational factors affecting the capital structure policies. Moreover, it also ignored the benefits of a higher EBIT resulting from expansion through debt.
Interst Coverage Ratios
Grand Metropolitan 1997
Describe briefly Diageo’s business, putting particular emphasis on the potential sources of risk, and your evaluation thereof. Identify major sources of risk for equity holders and for debtholders.
Describe Diageo's current approach to managing its capital structure. What are the key variables that guide its capital structure policy?
What factors should Diageo consider in determining its capital structure? What information would you collect and what analyses would you conduct in order to determine the appropriate level of gearing?
How does the Treasury Group's simulation work? What aspects of Diageo's business does it capture? What does it ignore? What key assumptions does it make? How could you improve the model to adjust any missing factors?
What are the managerial implications of the summary results shown in Figure 2 of the case? As Ian Cray, what questions would you ask the Treasury team in reviewing their work? What should Cray recommend for Diageo's gearing when it becomes a pure beverage alcohol business? Frame your recommendation in terms of a target level of interest coverage or a target bond rating.