Diageo

Advance Financial Management Case 4 |

Diageo Plc

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Group 5 |

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LI Yuanyuan | 1155036362 |

GUI Cheng | 1155038172 |

QUAN Junyu | 1155036370 |

WU Di | 1155038434 |

YU Tianqi | 1155036374 |

* Historical Overview

Diageo is the result of the merger of Grand Metropolitan and Guinness. Before the merger (1997), Grand Metropolitan had an EBIT interest coverage of 7, a ratio of EBIT over total debt of 25% and a credit rating of A. Guinness had an EBIT interest coverage of 12, a ratio of EBIT over total debt of 47% and a credit rating of AA. According to the post-merge capital structure (Appendix I), Diageo relied less on debt than on equity to finance its own assets. As year passed, it increased its use of debt, especially the short term debt, which can be told from the ratio of debt over assets. Even if it needed money, it resorted more to the short term debts. The EBIT interest coverage ratio also showed its capability of paying interest back. Furthermore, an increasing in account receivable indicated that it started to take advantage of sales credit and placed more on this as their business grew. Overall, Diageo was a conservative company which took serious about its usage of debt.

* Quantify the cost and benefit of different gearing policy with trade-off theory

To ameliorate the capital structure of Diageo, we apply for the trade-off theory. The trade-off theory can be depicted by the following equation.

VL = VU + PV (Interest Tax Shield) – PV (Financial Distress Costs)

In order to achieve the highest levered value possible given the unlevered value of the company fixed, we need to gradually increase the leverage level until the leveled value is maximized. For Diageo’s business prior to the sale of Pillsbury and spinoff of Burger King, the financial distress costs are simulated through Monte Carlo process with respect to different leverage levels, denoted by EBIT divided by interest expense. After attaining the data concerning financial...