What Is the Static Tradeoff Theory (textbook Version)? How Would You Apply It to Diageo’s Business Prior to the Sale of Pillsbury and Spinoff of Burger King?

What is the static tradeoff theory (textbook version)? How would you apply it to Diageo’s business prior to the sale of Pillsbury and spinoff of Burger King?

The static trade off theory attempts to explain the optimal capital structure in terms of the balancing act between the benefits of debt (tax shield from interest deduction) and the disadvantage of debt (from the increased expected bankruptcy costs). The company should decide how much debt financing and how much equity financing to distribute for better balancing the costs and benefits. And Firms try to balance the costs of financial distress against the tax benefits of debt (modeled as tax shields by MM theory) while making capital structure decisions on how much debt to use for funding various investments. Costs of financial distress include both bankruptcy costs (poor cash flows leading to bankruptcy in a highly levered position) and non-bankruptcy costs (increased cost of capital, ability to advantageously use commercial paper, supplier demanding stricter payment terms etc.).

Then we look into Diageo’s business prior to the sale of Pillsbury and spin-off of Burger King, firstly, we can find out that from June 30, 1998 to 2000, Diageo’s interest coverage ratios were at about 7. Because of the group’s policy to keep the interest coverage ratio within a range of 5 to 8 to maintain their credit rating of A+, Diageo is able to enjoy considerable benefits in the capital markets including more possible debt financing amount. From the figure in Monte Carlo Simulation as shown in Figure 2 in the case material, we could see that when interest coverage ratio is at around 4, the total sum of tax paid and costs of financial distress is minimized, which tells us that 4 is the historical optimal debt ratio for Diageo. This optimal interest coverage ratio is much less than Diageo’s maintained interest coverage ratio, which is at around 7. At the meantime, by observing the historical cash-flows, we can find that Diageo has considerably stable cash flows. So, if we apply the tradeoff theory to Diageo, we can conclude that they are in the left of optimal debt ratio, thus they can have a bigger debt ratio. As Diageo has maintained high credit ratings and high interest coverage ratios, it could maximize its tax shield by increasing its debt levels and using its cash positions to aggressively bid for targets like Seagram to grow its business.