Diageo Case

Diageo plc

Main focus of the case is to recommend a capital structure policy for the organization and develop a tradeoff between tax benefits of higher debts and cost of financial distress. Case provides details about the business model comprising of four divisions and history of the company. It also says firm is planning to divest noncore operations and consolidate the core business of beverage alcohol to reduce expense and increase synergy. Most Importantly, Case includes the key elements of business model and capital structure that have the potential of impacting financial strategy in following ways:-

High Interest Coverage and Future Strategy

As per the case, Diageo has interest coverage of 5x which is higher than interest coverage value of 4.2x, at which total of taxes paid and distress costs is the least as shown in Diageo’s Monte-Carlo simulation (shown below). Also, in the below simulation, its interest coverage ration should lie in the range of 5x to 3.6x to have optimal coverage.

Diageo future strategy is based on organic and inorganic expansion. Under inorganic growth scenario, Diageo needs $6 to $8 billion to acquire other players in the market. To finance these acquisitions, Diageo would raise additional debt from the market. To make this strategy effective, Diageo has to keep very low cost of borrowing, which can only be achieved by keeping high interest coverage ratio and credit rating in the investment grade range. This explains the Diageo’s strategy for maintaining the high interest coverage ratio.

Further, Diageo faces a risk of downgrade if its interest coverage ratio falls far below than 5x. In that case, its credit rating will fall to BBB (Non-Investment Grade) from A+ (Investment Grade). With Non-Investment Grade, it would be difficult for Diageo to raise cheap debt and to finance acquisitions.

In addition to inorganic growth, high interest