1. How has Diageo historically managed its capital structure? Diageo sought to maintain the low-debt (conservative) financial policies of the Guinness and Grand Met with goals to keep * its interest coverage ratio (EBITDA / Interest Payments) between 5 and 8 and * its EBITDA / Total Debt around 30-35%
Although not quite as conservative as other UK firms (with Equity/Assets ratios of 42%), it was successful in achieving these goals and retaining a credit rating of A+ (a rough average of Guinness’ AA and Grand Met’s A ratings) by re-levering the firm via * issuance of debt to repurchase and retire shares in fiscal years 1998 and then again in 1999 * and ensuring that cost of capital was managed down at each country level in keeping with its “Managing for Value” approach to employing capital
2. 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?
The static tradeoff theory suggests that firms try to balance the costs of financial distress against the benefits of a higher debt (higher tax shield as introduced by the MM theory) when making capital structure decisions to determine how much debt to use for funding operations and making capital investments. Costs of financial distress include both bankruptcy costs (poor cash flow leading to bankruptcy in a highly levered position) and non-bankruptcy costs (increased cost of capital, ability to advantageously use commercial paper, suppliers demanding stricter payment terms etc.) Diageo has maintained high credit ratings and kept its interest coverage high. 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. 3. Why is Diageo selling Pillsbury and spinning off Burger King? How might value be created through these transactions?
Diageo wants to focus exclusively on the...