Diageo Case Study

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BackgroundDiageo was formed in November 1997 from the merger of Grand Metropolitan plc andGuinness plc with a motivation to become the industry leader and expected cost savings ofnearly £ 290 million per year due to marketing synergies, reduction in head office and regionaloffice overhead expenses, and production and purchasing efficiencies. The firm comprised offour business segments, namely Spirits and Wine business, Guinness Brewing, Pillsbury, andBurger King. However, since the 1997 merger, Diageo’s stock performance has been laggingmarket indices. In September 2000, Paul Walsh, who was previously the CEO of the Pillsburysubsidiary, was named the group Chief executive of Diageo. According to the case, Walsh’snew strategy involved concentrating solely on beverage alcohol business. Continued growthcould come from organic growth or from potential acquisitions. This organic growth relied oncapital expenditures in the range of £ 400 – 500 million per year for the next five years. As perthe case, some of the non-official spending estimates for acquisition are as much as $6 to 8billion in the next three years; a “minimalist” scenario might involve very little acquisition, and amidrange estimate was about $2.5 million over five years. These acquisitions were consideredimportant considering the industry consolidation, among both suppliers and distributors, in thealcohol beverage business. Hence, the capital structure of the firm is critical in order to be ableto fund these acquisitions or growth opportunities. Capital StructurePost-merger, Diageo wanted to maintain the low-debt policies of Grand Metropolitan plcand Guinness plc in order to keep the interest coverage ratio between 5 and 8 times and theEBITDA/total debt ratio around 30-35%. Diageo was successful in achieving the low debtestimate by re-leveraging the firm through issuance of debt to repurchase shares and inestablishing a return that covered not only the operating costs, but also the cost of capitalemployed by its divisions (“Managing for Value”). Diageo was rated A+ (rough average of GrandMetropolitan plc and Guinness plc) after the merger and this rating was important to the firm asit could fetch financing more readily and paid lower promised yields than firms with lowerratings. Another benefit of such high rating was the ability to access short-term commercialpaper borrowings at rates lower than LIBOR, a rate quoted by larger firms for short-termunsecured loans. Short-term commercial paper contributed to approximately 47% of Diageo’sdebt with maturities of 6 months to 1 year. Costs of financial distress versus tax benefits of debtWith reference to class discussions and case notes, firms try to balance the costs offinancial distress against the tax benefits of