Diageo Plc

This report captures various capital

structure related issues faced by

our client - Diageo Plc. It outlines

existing capital structure practices

at Diageo followed by our

recommendations on the

companys future capital structure

Achint Malhotra (1449862)

Amandeep Arora (1441665)

Pikun Pattnaik (1437171)

We, on behalf of AAP Consulting, have the honor to work with our client Diageo Plc in providing

financing, capital structure, and risk advisory. Our firm has more than 10 years of experience in

financial management, M&A advisory, capital restructuring and risk consulting helping our clients

in making better and informed decisions in their businesses.

Our Client Diageo Plc. was formed in 1997 from the merger of Grand Metropolitan plc and Guinness plc. It was

the seventh largest food and beverages company with a market capitalization of ~ 24 billion,

annual sales of ~ 13 billion, and operations in more than 140 countries. The firm was organized in

four segments- Spirits and Wine business, Guinness Brewing, Pillsbury subsidiary (packaged

foods), Burger King subsidiary (fast-foods). In September 2000, Paul Walsh became the Group Chief

Executive of Diageo and started to consolidate Diageos operations to be primarily focused on the

beverage alcohol business, with the growth coming from organic growth or potential acquisitions.

Historical Capital Structure Up until 2000, capital structure policy of our client Diageo was conservative maintaining quite high

book equity to assets ratio inherited from its predecessors. Both Guinness and Grand Metropolitan

maintained very conservative capital structure to maintain a high level of credit worthiness. Both

used little debt for financing and as a result the rating agencies rated both these companies highly.

The bonds of the two firms were rated AA and A.

Upon the merger, Diageo maintained similar financing policies as the merged companies. Our client

maintained healthy interest coverage ratio- within a band of five to eight times. The new merged

entity was rated A+ by the rating agencies. In addition, the firm kept EBITDA/Total debt at ~30-

35%. We believe that company didnt fully utilize its debt capacity, leaving some amount of money

on the table because of under-leveraging. (Exhibit 1 shows the historical interest coverage ratio of

the firm)

With relative low volatility in ROA, strong credit rating and healthy financial ratios meant that our

client could increase its gearing without substantial increase in risks. Low level of equitys beta also

supports our viewpoint that earnings werent highly pro-cyclical. Our client hence was able seek

opportunities to access short-term commercial papers as a source of borrowing at attractive rates.

Approximately, 47% of our clients debt was issued in the form of short-term commercial papers,

which amounted to ~ 3.2 billion. Its ability to raise commercial papers would have been highly

limited if it had a rating of BBB.

Diageo vis--vis Static Trade-off theory The static trade off theory attempts to explain the optimal capital structure in terms of the

balancing act between the benefits of debt (tax shield from interest deduction) and the

disadvantage of debt (from the increased expected bankruptcy costs). Firms try to balance the

costs of financial distress against the tax benefits of debt (modeled as tax shields by MM theory)

while making capital structure decisions on how much debt to use for funding various investments.

Costs of financial distress include both bankruptcy costs (poor cash flows leading to bankruptcy in a

highly levered position) and non-bankruptcy costs (increased cost of capital, ability to

advantageously use commercial paper, supplier demanding stricter payment terms etc)

If we apply this model to our client Diageos business prior to the sale of Pillsbury and spin-off of

Burger King, in a historic structure based in lowers debt ratios we can see the optimal debt ratio

can be higher than historical debt ratio. We suggest that our client should borrow up to the point

where:

Marginal benefits of the tax shield = Marginal cost of financial distress

When this happen the debt increases the firm value by reducing the corporate tax bill. In case of our

client, the major issue is the measure of bankruptcy costs and the uncertainty of operating income.

The uncertain of operating income can be resolve by observe the historical cash-flows as the

company observed considerably stable cash flows in the alcohol business. So, if we apply the

tradeoff theory to our client, we can conclude that they are in the left of optimal debt ratio so they

can have a bigger debt ratio. Our client has maintained high credit ratings and high interest

coverage ratios. 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.

Our Recommendations The Monte Carlo model (Exhibit 4) undertook by the Corporate Finance and the Treasury team

presented a couple of significant trends and insights for Diageo. After careful consideration of the

input factors and results generated by the model, we at AAP Consulting believe that our client

should continue to make use of more leverage in terms of its expansion plans. This

recommendation comes in the light of Diageos ability and willingness to repay its debt obligations

along with availability of cheaper sources of financing.

Diageos beverage business enjoys continuous and stable cash flows, which in turn acts as a hedge

in terms of the repayment of interest and principal obligations of the debt. This is complemented by

the strong historical fundamental performance of the firm. The firm enjoyed strong financial ratios

like Interest Coverage ratio and strong credit ratings from the rating agencies. The firms

profitability as shown in Exhibit 2, highlights better profitability and less volatility as compared to

other industries. The average ROA for beverages was about 17.7% with a volatility of 1.9%. These

financials are pretty healthier than the competition.

Under such a situation, it makes perfect sense for our client Diageo to make the best utilization of

leverage. Considering our clients ability to raise financing through cheaper sources, it will end up

paying lesser finance costs and would even get the benefits of tax shields. One of the biggest

shortcomings of this model is that it ignores the potential benefits of leverage in terms of increase

in assets through acquisitions. This models accounts for only the tradeoff between tax shields and

financial distress. Diageo estimates it ROA to be 17.7% without the packaged (Pillsbury) and fast

food (Burger King) segments. With a midrange estimate of $2.5 billion in acquisitions (as per the

case and assuming its done with 100% leverage) over the next five years, our client can increase its

sales revenue and EBITDA at a corresponding rate. However, one might argue that interest

payments thus cost of debt would also increase. This argument is reasonable except for the fact

that the return of equity (ROE) of 22.3% is higher than the cost of debt of 22% even with a BBB

rating (exhibit 5). Moreover, our client can address any perceived extra costs of financial distress by

playing with the 1 billion advertising budget. Hence, I believe our client Diageo can confidently

pursue its acquisition strategies by increasing its leverage without having a financial distress.

We also recommend our client to maintain Interest Coverage Ratio of 3.5 to 5 times. With these

EBIT/Interest ratios, our client will be able to minimize the total costs of taxes and financial

distress. This will represent the most optimal combination of Interest Coverage ratio (Exhibit 3).

There are some other shortcomings of the existing model created by our client in-house. There

could be some significant risk factors that the firm did not capture. The most important inputs

considered were based on historical results. The focus remained around fluctuations in sales and

exchange rates. Since, there have been a couple of changes after the merger of the two entities to

form Diageo, there would a lot of changes affecting future projections. One significant area would be

taking into account the value of synergies and the effect of dilution/accretion of the Earnings per

share on the new entity. In addition, since our client would lay a lot of emphasis of organic growth

though major capital expenditures, we recommend taking into consideration the effect of

depreciation and capitalizing the costs of the future expansion plans and their effect on our clients

cash flows and profitability. Furthermore, in a situation of financial distress, our client could resort

to equity financing rather than facing a 20% reduction in the value of the firm. This existing

assumption is hard to substantiate.

Despite the missing risk factors, we continue with our recommendation to maintain strong interest

coverage ratios and continue expansion efforts with more leverage. However, we also recommend

taking into consideration the future projections and its impact on cash flows. We also recommend

considering various qualitative factors like integration issues and change in leadership post merger.

The end objective is to increase the firm profitability and increase shareholder value.

Appendices

Exhibit 1 Diageo Group Interest Coverage, 1997 - 2000

Exhibit 2

Industry returns on assets (EBIDTA/assets), with Diageo mix of businesses

Median industry returns on assets, 1950 - 1999

Exhibit 3 Output chart from model

Exhibit 4 Simplified flowchart of Monte Carlo Simulation

Exhibit 5 Selected data on bond market for 5 years notes, October 31, 2000