Background Diageo was formed in November 1997 from the merger of Grand Metropolitan plc and Guinness plc

with a motivation to become the industry leader and expected cost savings of nearly 290 million per year due to marketing synergies, reduction in head office and regional office overhead expenses, and production and purchasing efficiencies. The firm comprised of four business segments, namely Spirits and Wine business, Guinness Brewing, Pillsbury, and Burger King. However, since the 1997 merger, Diageos stock performance has been lagging market indices. In September 2000, Paul Walsh, who was previously the CEO of the Pillsbury subsidiary, was named the group Chief executive of Diageo. According to the case, Walshs new strategy involved concentrating solely on beverage alcohol business. Continued growth could come from organic growth or from potential acquisitions. This organic growth relied on capital expenditures in the range of 400 500 million per year for the next five years. As per the case, some of the non-official spending estimates for acquisition are as much as $6 to 8 billion in the next three years; a minimalist scenario might involve very little acquisition, and a midrange estimate was about $2.5 million over five years. These acquisitions were considered important considering the industry consolidation, among both suppliers and distributors, in the alcohol beverage business. Hence, the capital structure of the firm is critical in order to be able to fund these acquisitions or growth opportunities. Capital Structure Post-merger, Diageo wanted to maintain the low-debt policies of Grand Metropolitan plc and Guinness plc in order to keep the interest coverage ratio between 5 and 8 times and the EBITDA/total debt ratio around 30-35%. Diageo was successful in achieving the low debt estimate by re-leveraging the firm through issuance of debt to repurchase shares and in establishing a return that covered not only the operating costs, but also the cost of capital employed by its divisions (Managing for Value). Diageo was rated A+ (rough average of Grand Metropolitan plc and Guinness plc) after the merger and this rating was important to the firm as it could fetch financing more readily and paid lower promised yields than firms with lower ratings. Another benefit of such high rating was the ability to access short-term commercial paper borrowings at rates lower than LIBOR, a rate quoted by larger firms for short-term unsecured loans. Short-term commercial paper contributed to approximately 47% of Diageos debt with maturities of 6 months to 1 year. Costs of financial distress versus tax benefits of debt With reference to class discussions and case notes, firms try to balance the costs of financial distress against the tax benefits of debt (modeled as tax shields) while making decisions on how much debt to use for funding various investments. In Diageos case, the tax benefits were clear (with composite marginal tax rate of 27%) but the costs of financial distress were difficult to find. Typically, costs of distress include bankruptcy costs, where bad cash flows lead to bankruptcy in a high levered position, and other costs like increased cost of capital, stress during a price war with competition etc. Since Diageo has maintained it high credit ratings and interest coverage ratio, it could increase its tax

shield by issuing more debt and using the cash raised through this debt to acquire firms like Seagram to grow its alcohol beverage business. Besides acquisitions, Diageo agreed to sell its Pillsbury division to General Mills and showed interest to spin off Burger King through an initial public offering in order to focus exclusively on the beverage alcohol industry. Both Pillsbury and Burger King didnt fit with the other two segments, spirits/wine and brewing, due to incompatibilities with shared production, marketing, channeling and cost savings even though Pillsbury and Burger King had relatively stable cash flows. Divesting these segments allowed Diageo to raise financing for internal investments and external acquisitions that can be easily integrated into its core system, allowing it to enjoy certain synergies and efficiencies. Hence, understanding the costs and benefits of different gearing policies are important while evaluating a firms decisions. With the help of Monte Carlo analysis, Ian Simpson, Diageos Director of Corporate Finance and Capital Markets, and Adrian Williams, the firms Treasury Research Manager, generated multiple scenario results for EBIT and interest payments which further determined taxes paid, interest coverage ratio and credit rating. The probability of financial distress was high with higher interest payments but corresponded with high tax shield benefits. This model forecasts EBIT as a function of three uncertainties, namely return on assets (connected to operating cash flow), exchange rate, and interest rates. Based on this model alone (exhibit 8 in the case), Diageo should maintain an interest coverage ratio of 5 to 8, as the likelihood of financial distress is low in this range. This range indicates stable cash flows with good credit rating, while allowing Diageo to realize enough tax benefits. However, in my opinion, one of the disadvantages of this model is that it ignores the potential benefits of leverage in terms of increase in assets through acquisition. This models accounts for only the tradeoff between tax shields and financial distress. Diageo estimates it ROA to be 17.7% (Exhibit 7A in the case) 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, Diageo 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% (exhibit 4) is higher than the cost of debt of 22% even with a BBB rating (exhibit 5). Moreover, any perceived extra costs of financial distress could be addressed by playing with the 1 billion advertising budget. Hence, I believe Diageo can confidently pursue its acquisition strategies by increasing its leverage without having a financial distress.