How Has Diageo Historically Managed Its Capital Structure? How Does the Capital Structure Compare to Its Competitors?

1.How has Diageo historically managed its capital structure? How does the capital structure compare to its competitors?

Historically the capital structure of both Guinness and Metropolitan, the pre-existing companies before the 1997 merger, was characterized by reasonably little debt to finance themselves prior to the setting up of Diageo. This type of capital structure is indeed very common for the average British firms, which tend to prefer more conservative financial policies than companies in other countries (book value of equity represents 42% of the total assets). The policy to use little debt was reflected in the high debt ratings of the bond of the two companies, classified as Investment Grade (IG). In 1997, when Diageo was created, the main priority was to retain the policies of the merged companies, partially to maintain the status quo and partially because it was considered appropriate. An increase of its debt would have caused a debt rating fall to BBB from the current A rating and for the management this was valued as risky.

Using the Exhibit 4 we can make some comparisons between the company and its competitors: Diageo has a lower interest coverage compared to the competitors, which means has more difficulties in meeting its financial obligations and making interest payments on the debt. Based on the EBITDA/total debt indicator, Diageo has the weakest value, which suggest a lower ability in paying off its incurred debt.

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Comparison of book and market gearings

2.Discuss the issue of costs of financial distress for Diageo. Which should be relevant costs for the company? Do you expect the costs to be comparatively high or low (think of the costs conditional on entering financial distress and the probability of financial distress as key variables of financial distress costs)? Explain.

In facing a financial distress a company has to deal with direct, indirect and strategic costs. The direct ones involve expenses for legal and financial advisors and general administrative costs of bankruptcy proceedings. Diageo, operating in multiple countries with different regulations, would be highly exposed to these costs.