Diageo

1. Describe Diageo's current approach to managing its capital structure. What are the key variables that guide its capital structure policy?

Diageo’s current approach to managing capital structure is to focus on the core business of manufacture and distribution of alcoholic beverages and take on a higher level of debt for mergers and acquisitions. They have to keep the gearing at a level that reflects the tradeoff between the tax shields and the cost of distress.

The key variable is the firm’s interest coverage ratio. To maintain a good credit rating, Diageo has implemented the risk management policy to actively manage the capital to keep the interest cover ratio within the band of five to eight times, in the sense would help Diageo maintain the credit rating of A+. Maintaining the credit rating of A+ will make their debt financing much easier and be able to access to short-term commercial paper at an attractive rate. The book gearing ratios and the market gearing ratios give us a clear picture on how Diageo managed their right hand side of the balanced sheet differently compared to competitors.

2. 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?

Diageo should consider about the risk factors in determining its capital structure. As revealed from historical reviews, Diageo’s operating cash flow or ROA was driven by the fluctuations in sales and exchange rates. The risk resulted from the competitors’ mergers and acquisition should also be considered while determining the capital structure. Diageo should also think about the costs of financial distress at certain debt level. Company should collect information about similar companies with different debt levels, what their credit ratings were, what yield they paid on debt and try to estimate what the cost of the possibility of financial distress was....