Diageo was multinational companythat had operations in the food and beverage industry in 1997. Originallyestablished through a merger that took place between Grand Metropolitan and Guinness, the conglomerate later became one of the most important participant in the business industry. Owning to different factors (low borrowing cost, investor confidence), Diageo made the choice of holding a conventional capital design with low debt leverage. Three fundamental elements guided the capital structure regulations of Diageo. They comprised of Interest coverage ratios, EBIT to debt ratio and a target rating of A+. The simulation frameworkdesigned by the treasury team of Diageo distinctly suggested that the organization was not leveraged enough and could increase its market worth by increasing the debt levels and utilizing it to fund internal development and progress. Despite the fact that the simulation allowed a detailed assessmentfor the process of decision making; it was deficient in providing assessment regarding the operational elements that impacted the capital structure rules. Additionally, it also lacked in giving an insight about having an increased EBIT resulting from growth via debt.
Interst Coverage Ratios
Grand Metropolitan 1997
Describe briefly Diageo’s business, putting particular emphasis on the potential sources of risk, and your evaluation thereof. Identify major sources of risk for equity holders and for debtholders.
Describe Diageo's current approach to managing its capital structure. What are the key variables that guide its capital structure policy?
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?
How does the Treasury Group's simulation work? What aspects of Diageo's business does it capture? What does it ignore? What key assumptions does it make? How could you improve the model to adjust any missing factors?
What are the managerial implications of the summary results shown in Figure 2 of the case? As Ian Cray, what questions would you ask the Treasury team in reviewing their work? What should Cray recommend for Diageo's gearing when it becomes a pure beverage alcohol business? Frame your recommendation in terms of a target level of interest coverage or a target bond rating.