Essay About Has Diageo And High Credit Ratings Of Aa

How Has Diageo Historically Managed Its Capital Structure?
Q1. How has Diageo historically managed its capital structure?Prior to the merger of Guinness plc and Grand Metropolitan plc, both companies were utilizing relatively low debt to finance their operations, with D/E ratios of 0.53 and 1.06 respectively, which partially resulted in high credit ratings of AA and A. After the merger, Diageo maintained its original financial policies and acquired a credit rating of A+.Approximately 47% of Diageo’s debt was financed by short-term commercial paper with maturities of 6 months to one year. Thus, Diageo must maintain its long-term debt ratings so that its ability to raise commercial paper will not be impaired. In addition, the stock price of Diageo was not performing well after the merger, which made raising capital through equity financing an infeasible option. These were the underlying drivers for the treasury team of Diageo to keep the interest rate coverage ratio within a band of 5 to 8 times and the EBITDA/Total Debt at about 30% to 35%. Besides 1997, when the merger took place, the post-merger 1998-2000 D/E ratios of Diageo steadily averaged at around 1.5, which was a very low debt level, as shown in Exhibit 1. The sharp increase of D/E ratio from 1997 to 1998 resulted from the increase of the short-term debt and the decrease of the equity. Apparently, Diageo re-levered by repurchasing its shares through the issuance of new debt. Given that Diageo’s stock price had lagged versus broad market indices, such strategy might also intend to regain the confidence of the investors and to stabilize the stock price. See Figure 1 in the case, Diageo put great efforts in keeping their interest coverage ratio within the band since there was a dilemma between the need for debt financing and the need for credit rating. Obviously, Diageo re-levered whenever the interest coverage ratio went beyond the ceiling of 8. Diageo’s financial policies were not so conservative compare to its major competitors according to appendix Table 1. However, these indicators were not enough to criticize its capital structure in that there was a tradeoff between efficiency and risk aversion, and different company applied different strategies. In sum, the Diageo managed the capital structure quite well in absolute term, though some key indicators might not be as conservative as its major competitors.Q2. 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 tradeoff theory of finance textbooks is between the tax benefits of debt and the cost of financial distress[1] when a firm decides on its capital structure. Since interest expense is tax-deductible, raising funds by debt avoids certain tax expense which otherwise would have been incurred by equity fundraising. However, high gearing increases the cost of financial distress, exposing the company to a higher degree of risks in a competitive market (e.g. vulnerability to price war, damage of brand image, opportunity costs of profitable investments). The cost of financial distress could result in both direct (financial and legal) and indirect (strategic) costs, and also give rise to higher cost of capital followed by lower credit rating and limited access to advantageous commercial paper.