Diageo Simulation
Table of Content
1. Introduction 1
2. The decisions to sell Pillsbury and list Burger King 1
2.1 Volatility of cash flows 2
2.2 Probability of financial distress 3
2.3 Increased valuation of Diageo 3
2.3.1 Comparables 3
2.3.2 Cash flow 4
2.3.3 Increased leverage 4
2.3.4 Acquisitions 4
3. Implicit assumptions of the Monte Carlo simulation 4
3.1 Capital expenditure 5
3.2 Investment in intangibles 5
3.3. Working Capital 5
3.4 Consistency between implicit and explicit assumptions 5
4. Description of the working of the simulation 6
5. The results of the simulation in comparison with Diageo 's stated capital structure policy 6
5.1 Diageo 's stated capital structure policy 6
5.2 The results of the Monte Carlo simulation 7
5.3 Increase in gearing for Diageo 7
6. Conclusion 8
References II
1. Introduction
When Grand Metropolitan plc and Guiness plc merged in 1997, they created Diageo plc, the seventh largest food and drink company in the world. With annual …show more content…
sales toping £13 billion and a market capitalization of almost £24 billion, Diageo was primed to become even more profitable, as the merger should help Diageo top the industry while also saving an estimated £290 million per year on overhead expenses and production and purchasing. Diageo was split into four business segments, the largest its Spirits and Wine business, holding the leading market share in the US and UK with revenues of £5 billion. With brand names like Smirnoff, Johnnie Walker, and Tanqueray the Spirits and Wine business had 15% operating margins and 15% growth of total operating profits. Guinness Brewing was Diageo’s second largest division, producing and selling beer around the globe. Diageo was merging Guinness Brewing with the Spirits and Wine business to save an estimated £130 million per year by integrating the distribution channels globally (Chacko and Tufano 2003, p. 1). Pillsbury, a leader in packaged foods, and Burger King, a fast-food restaurant chain, made up Diageo’s third and fourth business segments respectively, in terms of size. By 2000, Diageo was an underperforming stock relative to the broad market indices, and the new Group Chief Executive of Diageo declared a new strategy for Diageo moving forward.
2. The decisions to sell Pillsbury and list Burger King
There are several reasons why Diageo announced the divestitures of Pillsbury and Burger King.
The main reason Diageo chose to sell Pillsbury and list Burger King was a change in business strategy, which would allow it to concentrate on its most important and profitable beverage alcohol business. The two divisions of Spirits and Wine and Guinness Brewing were the largest business segments of Diageo. Paul Walsh, the Group Chief Executive of Diageo, stated that he wanted to focus on “beverage alcohol, driving growth through innovation around our unrivalled portfolio of brands and providing an improved base for sustained profitable top line growth” (Chacko and Tufano 2003, p. 2). By eliminating the food segment from the portfolio, and focusing solely on beverage spirits, the company sought to achieve sustainable growth in the future, at higher rates than the 8% currently brought in by the Spirits and Wine business. Diageo’s strategy to focus on premium brands and pricing boosted their operating profit growth
rate.
With the sale of Pillsbury to General Mills, Diageo would bring in $5.1 billion in cash, plus an additional 141 million shares of newly issued General Mills stock; the approximate value of the additional shares was $5.4 billion (Chacko and Tufano 2003, p. 2). This situation benefited both General Mills and Diageo, as Diageo would now own 33% of the new General Mills/Pillsbury business and could still benefit from potential synergy effects from Pillsbury’s distribution networks. General Mills itself was valuated quite low, with a market to book ratio of -39.9 times (Chacko and Tufano 2003, p. 11). Assuming a higher valuation in future due to synergy effects, Diageo could benefit from increasing share prices. Presumably, the expected cash flow from the sale of Pillsbury was worth more to Diageo than the value growth of keeping the business. With the potential sale of its sideline business Pillsbury to one of the strongest competitors in the food industry in General Mills against 33% of shares, Diageo was able to benefit on further acquisition synergies, like increased economies of scales within the new company General Mills / Pillsbury, as they remained shareholders.
Thirdly, the sale of assets provided the firm with cash. Diageo announced that it would list Burger King through an initial public offering (IPO). Diageo decided to float 20% of Burger King immediately and due to tax reasons, Diageo would float the remaining balance of 80% after 2002. By floating Burger King, Diageo directly received $5.1 billion in cash and had the certainty of future incoming cash flows, while strategically avoiding a significant tax hit. The divestments will provide Diageo with significant compensation. This money is needed due to the accelerating consolidations in the alcoholic beverage industry, which forces Diageo to be open to possible acquisitions. Furthermore, the cash helps to avoid a financial distress and being unable to meet the expectations of the bond and equity holders of Diageo.
Finally, the new strategy of Diageo was necessitated by their stock underperformance versus the FTSE index since the merger in 1997 and the inability to meet the expectations of their shareholders. By refocusing on the two more profitable business segments, Diageo is expected to boost the shareholders return.
2.1 Volatility of cash flows
The decision to sell Pillsbury and Burger King has direct implications on the volatility of the firm’s cash flows and, ultimately, on profits and future success. There are two effects (working in opposite directions) to consider when evaluating the impact of investments: On the one hand there is generally a diversification effect through a heterogeneous product portfolio and on the other hand an effect caused by differences in the return volatilities of product industries. When we discuss about divestures we approach these effects from the opposite side. In financial terms diversification always sounds good but the question is if it 's important or not in this specific case.
By focusing on the industry returns on assets (EBITDA / Assets) and their volatility, we can look at the impact of the divestures on the volatility of cash flows. As Diageo was planning the sale of its food sectors, we compare the weighted average volatility of the alcoholic beverages sector to the volatility of the packages food and fast food sectors. As the industry average firm volatility of fast food is at 4.4% and of packaged food at 3.6%, these are both higher than the spirits industry at 3.4% and therefore should not increase Diageo’s volatility (Chacko and Tufano, 2003, p. 14, Exhibit 7A). Chacko and Tufano (2003) show however that the average industry ROA volatility remains at the same level of 1.9% even after the spinoff of the packaged food and fast food divisions. We assumed that Diageo’s decision to sell its food component would lessen its diversification and make the firm’s future success more dependent on a beneficial economic situation. However we have seen, the divestitures of Pillsbury and Burger King would not have negative effects on the volatility of Diageo’s cash flows and can conclude that there is no negative impact on the volatility of cash flows. Additionally, with the sales of Pillsbury and Burger King, Diageo also benefitted from immediate cash and gained the ability to invest in their key segments.
2.2 Probability of financial distress
While working on the sale of Pillsbury and the listing of Burger King, Diageo was also playing with the idea of increasing debt to finance the company. With an increase in debt would come a decrease in the interest coverage, defined as EBIDTA/interest expense. Diageo wanted to keep its interest coverage ratio between five and eight, in order to keep its A+ credit rating. They therefore decided that increasing debt “seemed a bit risky” (Chacko and Tufano 2003, p.3) and stuck with the lower debt financial policies of the merged institutions.
According to Chacko and Tufano 2003 ( p. 11, Exhibit 4), interest coverage of comparable spirits and beer producing companies ranges from 4.1 (Carlsberg) to 15.3 (Heineken), averaging 9.22 across 5 comparable companies. Comparable packaged food businesses had an average interest coverage average of 7.88, and comparable restaurant businesses an average of 7.9. The outcome of the Monte Carlo model with the lowest present value of taxes plus cost of distress suggests interest coverage of about 4.2 (Chacko and Tufano 2003, p. 16, Figure 2).
Looking at the high growth rates of the alcoholic-beverages industry, financial distress seemed unlikely. Bearing in mind Diageo 's large and stable internal cash flows, it is reasonable to assume that after the restructuring, Diageo’s business would be capable of achieving even lower deadweight costs of leverage than before. As an A-rated borrow, Diageo would be in a good position to easily access large amounts of short-term debt.
2.3 Increased valuation of Diageo
The possible effect of the above-mentioned divestitures on Diageo’s valuation can be assessed from several points of view and can help determine whether the changes will increase the valuation of Diageo.
2.3.1 Comparables
According to Chacko and Tufano (2003) comparable alcohol companies (Allied Domecq and Pernod Ricard) maintain average P/E multiples of 12.3 as well as an EV/EBIT multiple of 11.6 on average (p. 11, Exhibit 4). The beer industry comparables with average P/E multiples and EV/EBIT multiples of 22.2 and 16.9, the packaged food industry has averages of 21.8 and 13.2 and the restaurants industry 18.7 and 14.3. An interpretation from this side is virtually impossible. First of all, there are many other factors affecting the P/E and the EV/EBIT multiples. Secondly, the limited size of the comparative groups prevents a deep analysis. Nevertheless, we expect Diageo to enjoy higher multiples than on average because the stable cash flows and high credit rating. These finding should be recognized by the market, and should therefore not decrease valuation substantially on the basis of within-industry comparison.
2.3.2 Cash flow
Based on the above volatility of cash flows analysis, the divestitures of Pillsbury and Burger King should at the very least stay the same or even decrease. Stable cash flows affect Diageo positively, as it allows for an increase in leverage. Stable internal cash flows should also increase valuation because it signals that Diageo has the ability to pay its debt to creditors on time, with the cash on hand.
2.3.3 Increased leverage
As Diageo increased its leverage, the additional debt increased the present value of the tax shield, while distress costs remain low. The new debt can also be used to sustain growth of Diageo’s spirits and beer business, which will eventually benefit the shareholders through dividends and a higher stock price. The increased leverage would help Diageo in its new focus on the alcohol industry without raising debt so much that Diageo could no longer “meet the expectations of the bondholders and equity holders of the firm” (Chacko and Tufano 2003, p. 7).
2.3.4 Acquisitions
Future acquisitions in the alcohol beverage industry could also grow Diageo and lead to an increased valuation. Higher cost savings in its distribution system, manufacturing, and an increase its overall ability to reach consumers would be some of the benefits of these acquisitions. The divestitures would give Diageo more funds to expand its portfolio through vertical integration. Future acquisitions were estimated to cost Diageo as much as $6 to 8 billion over the coming three years (Chacko and Tufano 2003, p. 3), so having extra cash to quickly jump on opportunities was essential.
Finally, to conclude this section, by listing Burger King and selling Pillsbury, Diageo will have a more vertically integrated portfolio with respect to alcohol beverages. Based on that Diageo will also achieve a higher share price because of the decrease in cash flow volatility, which implies less risk, a lower required return on equity, and a higher discounted cash flow valuation.
3. Implicit assumptions of the Monte Carlo simulation
The Monte Carlo simulation used by Diageo has many implicit assumptions. Local EBIT, interest rates, foreign exchange, and market correlations are the random variables simulated in this model. The model assumes that the correlation between these random variables is constant (Chacko and Tufano 2003, p. 15, Exhibit 8).
3.1 Capital expenditure
The Monte Carlo simulation for Diageo simulates the present value of taxes paid and financial distress costs paid, and additionally accounts for three unknowns: EBIT as a percentage of assets, the interest rate, and the currency exchange rate. The EBIT is simulated with a normally distributed average return on assets (ROA) of 18% and with a standard deviation of 4%. Depending on how the firm is geared, the interest rate is calculated as rate-dependent spread over the base rate, with the credit spread for different ratings fixed. The Monte Carlo simulation assumes the assets will continue to grow at the current market interest rate unless the firm is suffering from financial distress. The interest rates used are all linked to the US interest rate and credit spreads for different ratings assumed fixed.
3.2 Investment in intangibles
The model included no major investments, like investments and divestures, and also did not allow for new equity issues. This means that no extra investment (e.g. acquisitions) other than depreciation and amortization are made, although they were relatively low in the industry (Chacko and Tufano 2003, p. 5). All interest is charged on a floating-rate basis. The model also holds the assumptions that there is constant currency and maturity mix of debt.
3.3. Working Capital
Working capital, assets minus current liabilities, is not expressly modeled in the simulation. Excess cash flow is used to pay down debt; conversely, a shortage of cash is primarily financed by the issuing new debt, and also by cutting both expenses and dividends payout (Chacko and Tufano 2003, p. 6), therefore cash balance at the end of the year should be zero. Excess cash flow accrues as the remaining cash after the payment of interest, taxes, and dividends – the model assumes regular cash payments to investors. There is no incoming cash from equity. Cash expenditures on investments or incoming cash from divestitures are assumed to equal zero. The excess cash therefore can be responsible for a change of the working capital into negative or positive values.
3.4 Consistency between implicit and explicit assumptions
The Monte Carlo simulation has the explicit assumption of no major investments. This clashes with the implicit assumption of mixed maturity of debt, as to make a major investment Diageo may have to take out a large sum of new debt, throwing off the balance of mixed maturity time.
The simulation also explicitly assumes no new equity issues, but this could affect the implicit assumption of the EBIT calculation, as assets are used to calculate not only EBIT but ROA as well and could also strongly influence the cash flows that are part of the simulation.
The model also explicitly defines financial distress is defined with an interest coverage ratio <1. In case of any financial distress a permanent reduction in firm value of 20% is simulated.
The interest rates are all linked to the US interest rate and the fixed credit spread for different ratings. But in reality Diageo has offices in 110 countries, so they can borrow money wherever the rates are attractive. We would like to amend that these assumptions lead to very vague results.
4. Description of the working of the simulation
Monte Carlo methods are a class of stochastic simulation models that rely on repeated random sampling to compute their results. This form of simulation is used to understand the final distribution of outcomes and not only the expected values. It is therefore mostly suited for calculations when the underlying problem cannot be solved by a deterministic algorithm.
The present value of taxes paid and financial distress costs paid are simulated across a set of gearing policies. The forecasted EBIT as percentage of assets accounts for three uncertainties: The ROA for each geographical region, interest rate paid on the firm 's debt, and the currency exchange rates. The simulation for the EBIT uses an average return on assets (ROA), which is assumed to have normal distribution with mean of 18% and a standard deviation of 4%.
The model calculated for each gearing policy an interest rate and the total interest that the company would pay every year. The interest coverage ratio and the tax paid is determined by earnings and interest.
The Monte Carlo simulation issued new debt to finance a cash shortfall. The excess cash flow that the business generated was used to pay down outstanding debt (Chacko and Tufano 2003, p. 6). Whenever EBIT-Interest-Taxes-Total Dividends is negative, the simulation has new debt being raised (Chacko and Tufano 2003, p. 6). Regardless of the nature of a shortfall, it is a significant concern for a company, and is usually corrected promptly through short-term loans or equity injections. This assumption is out of touch with reality because a firm would probably rather cut dividends instead of raise debts. Furthermore, Diageo had a lot of retained earnings which could have been used to pay negative results or even dividends. Raising debts would be unusual way for Diageo to handle deficits.
5. The results of the simulation in comparison with Diageo 's stated capital structure policy
5.1 Diageo 's stated capital structure policy
Diageo was formed in November 1997 based on a merger between Guinness plc and Grand Metropolitan plc. Both firms had highly rated bonds (AA and A respectively) and were running with little debt. When the two firms merged, they decided to retain the financial policies of the merged firms and to attempt to keep the interest cover ratio (ICR) between five to eight. The ICR is measured as EBITDA divided by the interest payments. As a result of the stated capital structure policy, Diageo was rated A+.
Diageo was intent on keeping the interest coverage above 5, as if it fell below, there would be a chance of credit downgrading. The treasury team found that the firm’s interest coverage ratio was a critical value when rating agencies determine bond ratings. Analysts within Diageo had determined that if their rating was to fall to a BBB rating, it would only be able to raise only $5-8 billion in debt, and with a BB rating, less than $5 billion. Diageo’s competitors generally averaged a higher IRC (Chacko and Tufano, p. 11-12, Exhibit 4) to obtain an A+ rating. Due to the stability of Diageo brands, they could more easily raise debt than other A+ rated companies.
The strong credit rating benefitted Diageo in multiple ways. First of all, a higher credit rating leads to a lower debt interest rate. When firms with better ratings borrow, they are given better interest rates than those with lower ratings, even if the firms can borrow the same amount. In addition, Diageo was able to raise a relatively big amount of debt within a short period of time. This was supported by deep capital markets for highly rated firms such as Diageo. Diageo might have been able to raise additional debt of $8 billion in 12 months (while maintaining the A+ rating). A second benefit was the ability to access short-term commercial papers at attractive rates. Diageo was able to borrow a large part of its debt through commercial paper (47%) because of the high rating. With a BBB rating or lower, Diageo’s ability to raise commercial paper would have been highly limited.
Regarding the fixed assets, Diageo estimated spending about £400-500 million per year for the next five years to modernize existing production facilities and support organic growth (Chacko and Tufano 2003, p. 2).
5.2 The results of the Monte Carlo simulation
The company’s optimal capital structure is influenced by multiple channels. As a result of this, the optimal gearing cannot be found with a straightforward arithmetic problem. Assuming that the models output is reasonable, we see that the optimal gearing should imply an ICR of 4.2. This is lower than Diageo’s stated target range of five to eight, which is expected to be necessary to keep the high rating. A downgrade from A+ to BBB would yield in a higher interest rate and make it harder to raise financing.
5.3 Increase in gearing for Diageo
More debt could decrease the average capital cost, which would optimize the capital structure (Volkart 2008)). We can show this using the WACC as a measure of cost of capital1. As debt is less costly than the equity (, an increase of gearing will lower the WACC. On the other hand, raising more debt will result in a rating downgrade and also make the firm riskier. As a result, the stakeholders will require a higher return on equity (ROE). The increase of the cost of equity will effectively raise the WACC. As a result, the cost of equity will offset some benefits of increasing debt. When a specific point of debt is exceeded, the WACC goes up. Running with high debt and less equity, the firm risks becoming insolvent if the business takes a turn for the worse. As a result, the cost of debt increases which is reflected in the cost of bankruptcy and the cost of financial distress.
Apart from the trade-off between tax benefits of debt and costs of financial distress there are other variables to be taken into account when considering a change of the capital structure. There are more negative consequences which we want to point out. First, a rating downgrade may send a bad signal to the investors. This could lead to a negative effect on the stock price because the investors fear the bankruptcy. Diageo would not anymore be able to access the attractive short-term commercial paper (CP) borrowings as readily. Considering that roughly half of Diageo’s debt consists of such CP borrowings, this might be a source for concern. Furthermore the reputation might suffer and customers’ and suppliers’ perception might also change. Secondly, Diageo loses its financial flexibility, especially in times of stress. The possibilities to react fast in those times are bounded as the enhancement of debt is limited (Volkart 2008). For example, it would be difficult for Diageo to compete in a “price war”. Another important implication of a higher gearing and Diageo’s subsequent lower rating is that the firm’s ability to raise additional debt to fund acquisitions would be negatively affected.
Taking into account all those above arguments, we would not advise Diageo to increase its gearing.
6. Conclusion
We believe that the strategy switch from a more diversified and stable holding structure to a more focused and concentrated business could lead to higher earnings and a gain in the overall alcohol beverage market share. This new market position combined with the planned new acquisitions could lead to a future rating upgrade. However, these are only estimations and therefore the overall negative impact from the higher gearing offsets the chances of a value creation for the company. Keeping in mind possible further acquisitions, we have to state that an increase in debt and therefore a loss of financial flexibility is not the most helpful solution for Diageo, as they should focus on raising the stock performance to the market indices, and becoming the market leader in alcohol beverages through organic growth and acquisitions using the capital structure policy that they already have in place.
References
Brealey, Richard, and Myers, Stewart, and Allen, Franklin. 2014. Principles of Corporate Finance (McGraw-Hill Education, UK).
Chacko, George, and Tufano, Peter. 2003. “Diageo plc” Harvard Business School.
Volkart, Rudolf, and Alexander F. Wagner. 2008. Corporate Finance: Grundlagen von Finanzierung und Investition (Versus Verlag, Zürich).
1. Introduction 1
2. The decisions to sell Pillsbury and list Burger King 1
2.1 Volatility of cash flows 2
2.2 Probability of financial distress 3
2.3 Increased valuation of Diageo 3
2.3.1 Comparables 3
2.3.2 Cash flow 4
2.3.3 Increased leverage 4
2.3.4 Acquisitions 4
3. Implicit assumptions of the Monte Carlo simulation 4
3.1 Capital expenditure 5
3.2 Investment in intangibles 5
3.3. Working Capital 5
3.4 Consistency between implicit and explicit assumptions 5
4. Description of the working of the simulation 6
5. The results of the simulation in comparison with Diageo 's stated capital structure policy 6
5.1 Diageo 's stated capital structure policy 6
5.2 The results of the Monte Carlo simulation 7
5.3 Increase in gearing for Diageo 7
6. Conclusion 8
References II
1. Introduction
When Grand Metropolitan plc and Guiness plc merged in 1997, they created Diageo plc, the seventh largest food and drink company in the world. With annual …show more content…
sales toping £13 billion and a market capitalization of almost £24 billion, Diageo was primed to become even more profitable, as the merger should help Diageo top the industry while also saving an estimated £290 million per year on overhead expenses and production and purchasing. Diageo was split into four business segments, the largest its Spirits and Wine business, holding the leading market share in the US and UK with revenues of £5 billion. With brand names like Smirnoff, Johnnie Walker, and Tanqueray the Spirits and Wine business had 15% operating margins and 15% growth of total operating profits. Guinness Brewing was Diageo’s second largest division, producing and selling beer around the globe. Diageo was merging Guinness Brewing with the Spirits and Wine business to save an estimated £130 million per year by integrating the distribution channels globally (Chacko and Tufano 2003, p. 1). Pillsbury, a leader in packaged foods, and Burger King, a fast-food restaurant chain, made up Diageo’s third and fourth business segments respectively, in terms of size. By 2000, Diageo was an underperforming stock relative to the broad market indices, and the new Group Chief Executive of Diageo declared a new strategy for Diageo moving forward.
2. The decisions to sell Pillsbury and list Burger King
There are several reasons why Diageo announced the divestitures of Pillsbury and Burger King.
The main reason Diageo chose to sell Pillsbury and list Burger King was a change in business strategy, which would allow it to concentrate on its most important and profitable beverage alcohol business. The two divisions of Spirits and Wine and Guinness Brewing were the largest business segments of Diageo. Paul Walsh, the Group Chief Executive of Diageo, stated that he wanted to focus on “beverage alcohol, driving growth through innovation around our unrivalled portfolio of brands and providing an improved base for sustained profitable top line growth” (Chacko and Tufano 2003, p. 2). By eliminating the food segment from the portfolio, and focusing solely on beverage spirits, the company sought to achieve sustainable growth in the future, at higher rates than the 8% currently brought in by the Spirits and Wine business. Diageo’s strategy to focus on premium brands and pricing boosted their operating profit growth
rate.
With the sale of Pillsbury to General Mills, Diageo would bring in $5.1 billion in cash, plus an additional 141 million shares of newly issued General Mills stock; the approximate value of the additional shares was $5.4 billion (Chacko and Tufano 2003, p. 2). This situation benefited both General Mills and Diageo, as Diageo would now own 33% of the new General Mills/Pillsbury business and could still benefit from potential synergy effects from Pillsbury’s distribution networks. General Mills itself was valuated quite low, with a market to book ratio of -39.9 times (Chacko and Tufano 2003, p. 11). Assuming a higher valuation in future due to synergy effects, Diageo could benefit from increasing share prices. Presumably, the expected cash flow from the sale of Pillsbury was worth more to Diageo than the value growth of keeping the business. With the potential sale of its sideline business Pillsbury to one of the strongest competitors in the food industry in General Mills against 33% of shares, Diageo was able to benefit on further acquisition synergies, like increased economies of scales within the new company General Mills / Pillsbury, as they remained shareholders.
Thirdly, the sale of assets provided the firm with cash. Diageo announced that it would list Burger King through an initial public offering (IPO). Diageo decided to float 20% of Burger King immediately and due to tax reasons, Diageo would float the remaining balance of 80% after 2002. By floating Burger King, Diageo directly received $5.1 billion in cash and had the certainty of future incoming cash flows, while strategically avoiding a significant tax hit. The divestments will provide Diageo with significant compensation. This money is needed due to the accelerating consolidations in the alcoholic beverage industry, which forces Diageo to be open to possible acquisitions. Furthermore, the cash helps to avoid a financial distress and being unable to meet the expectations of the bond and equity holders of Diageo.
Finally, the new strategy of Diageo was necessitated by their stock underperformance versus the FTSE index since the merger in 1997 and the inability to meet the expectations of their shareholders. By refocusing on the two more profitable business segments, Diageo is expected to boost the shareholders return.
2.1 Volatility of cash flows
The decision to sell Pillsbury and Burger King has direct implications on the volatility of the firm’s cash flows and, ultimately, on profits and future success. There are two effects (working in opposite directions) to consider when evaluating the impact of investments: On the one hand there is generally a diversification effect through a heterogeneous product portfolio and on the other hand an effect caused by differences in the return volatilities of product industries. When we discuss about divestures we approach these effects from the opposite side. In financial terms diversification always sounds good but the question is if it 's important or not in this specific case.
By focusing on the industry returns on assets (EBITDA / Assets) and their volatility, we can look at the impact of the divestures on the volatility of cash flows. As Diageo was planning the sale of its food sectors, we compare the weighted average volatility of the alcoholic beverages sector to the volatility of the packages food and fast food sectors. As the industry average firm volatility of fast food is at 4.4% and of packaged food at 3.6%, these are both higher than the spirits industry at 3.4% and therefore should not increase Diageo’s volatility (Chacko and Tufano, 2003, p. 14, Exhibit 7A). Chacko and Tufano (2003) show however that the average industry ROA volatility remains at the same level of 1.9% even after the spinoff of the packaged food and fast food divisions. We assumed that Diageo’s decision to sell its food component would lessen its diversification and make the firm’s future success more dependent on a beneficial economic situation. However we have seen, the divestitures of Pillsbury and Burger King would not have negative effects on the volatility of Diageo’s cash flows and can conclude that there is no negative impact on the volatility of cash flows. Additionally, with the sales of Pillsbury and Burger King, Diageo also benefitted from immediate cash and gained the ability to invest in their key segments.
2.2 Probability of financial distress
While working on the sale of Pillsbury and the listing of Burger King, Diageo was also playing with the idea of increasing debt to finance the company. With an increase in debt would come a decrease in the interest coverage, defined as EBIDTA/interest expense. Diageo wanted to keep its interest coverage ratio between five and eight, in order to keep its A+ credit rating. They therefore decided that increasing debt “seemed a bit risky” (Chacko and Tufano 2003, p.3) and stuck with the lower debt financial policies of the merged institutions.
According to Chacko and Tufano 2003 ( p. 11, Exhibit 4), interest coverage of comparable spirits and beer producing companies ranges from 4.1 (Carlsberg) to 15.3 (Heineken), averaging 9.22 across 5 comparable companies. Comparable packaged food businesses had an average interest coverage average of 7.88, and comparable restaurant businesses an average of 7.9. The outcome of the Monte Carlo model with the lowest present value of taxes plus cost of distress suggests interest coverage of about 4.2 (Chacko and Tufano 2003, p. 16, Figure 2).
Looking at the high growth rates of the alcoholic-beverages industry, financial distress seemed unlikely. Bearing in mind Diageo 's large and stable internal cash flows, it is reasonable to assume that after the restructuring, Diageo’s business would be capable of achieving even lower deadweight costs of leverage than before. As an A-rated borrow, Diageo would be in a good position to easily access large amounts of short-term debt.
2.3 Increased valuation of Diageo
The possible effect of the above-mentioned divestitures on Diageo’s valuation can be assessed from several points of view and can help determine whether the changes will increase the valuation of Diageo.
2.3.1 Comparables
According to Chacko and Tufano (2003) comparable alcohol companies (Allied Domecq and Pernod Ricard) maintain average P/E multiples of 12.3 as well as an EV/EBIT multiple of 11.6 on average (p. 11, Exhibit 4). The beer industry comparables with average P/E multiples and EV/EBIT multiples of 22.2 and 16.9, the packaged food industry has averages of 21.8 and 13.2 and the restaurants industry 18.7 and 14.3. An interpretation from this side is virtually impossible. First of all, there are many other factors affecting the P/E and the EV/EBIT multiples. Secondly, the limited size of the comparative groups prevents a deep analysis. Nevertheless, we expect Diageo to enjoy higher multiples than on average because the stable cash flows and high credit rating. These finding should be recognized by the market, and should therefore not decrease valuation substantially on the basis of within-industry comparison.
2.3.2 Cash flow
Based on the above volatility of cash flows analysis, the divestitures of Pillsbury and Burger King should at the very least stay the same or even decrease. Stable cash flows affect Diageo positively, as it allows for an increase in leverage. Stable internal cash flows should also increase valuation because it signals that Diageo has the ability to pay its debt to creditors on time, with the cash on hand.
2.3.3 Increased leverage
As Diageo increased its leverage, the additional debt increased the present value of the tax shield, while distress costs remain low. The new debt can also be used to sustain growth of Diageo’s spirits and beer business, which will eventually benefit the shareholders through dividends and a higher stock price. The increased leverage would help Diageo in its new focus on the alcohol industry without raising debt so much that Diageo could no longer “meet the expectations of the bondholders and equity holders of the firm” (Chacko and Tufano 2003, p. 7).
2.3.4 Acquisitions
Future acquisitions in the alcohol beverage industry could also grow Diageo and lead to an increased valuation. Higher cost savings in its distribution system, manufacturing, and an increase its overall ability to reach consumers would be some of the benefits of these acquisitions. The divestitures would give Diageo more funds to expand its portfolio through vertical integration. Future acquisitions were estimated to cost Diageo as much as $6 to 8 billion over the coming three years (Chacko and Tufano 2003, p. 3), so having extra cash to quickly jump on opportunities was essential.
Finally, to conclude this section, by listing Burger King and selling Pillsbury, Diageo will have a more vertically integrated portfolio with respect to alcohol beverages. Based on that Diageo will also achieve a higher share price because of the decrease in cash flow volatility, which implies less risk, a lower required return on equity, and a higher discounted cash flow valuation.
3. Implicit assumptions of the Monte Carlo simulation
The Monte Carlo simulation used by Diageo has many implicit assumptions. Local EBIT, interest rates, foreign exchange, and market correlations are the random variables simulated in this model. The model assumes that the correlation between these random variables is constant (Chacko and Tufano 2003, p. 15, Exhibit 8).
3.1 Capital expenditure
The Monte Carlo simulation for Diageo simulates the present value of taxes paid and financial distress costs paid, and additionally accounts for three unknowns: EBIT as a percentage of assets, the interest rate, and the currency exchange rate. The EBIT is simulated with a normally distributed average return on assets (ROA) of 18% and with a standard deviation of 4%. Depending on how the firm is geared, the interest rate is calculated as rate-dependent spread over the base rate, with the credit spread for different ratings fixed. The Monte Carlo simulation assumes the assets will continue to grow at the current market interest rate unless the firm is suffering from financial distress. The interest rates used are all linked to the US interest rate and credit spreads for different ratings assumed fixed.
3.2 Investment in intangibles
The model included no major investments, like investments and divestures, and also did not allow for new equity issues. This means that no extra investment (e.g. acquisitions) other than depreciation and amortization are made, although they were relatively low in the industry (Chacko and Tufano 2003, p. 5). All interest is charged on a floating-rate basis. The model also holds the assumptions that there is constant currency and maturity mix of debt.
3.3. Working Capital
Working capital, assets minus current liabilities, is not expressly modeled in the simulation. Excess cash flow is used to pay down debt; conversely, a shortage of cash is primarily financed by the issuing new debt, and also by cutting both expenses and dividends payout (Chacko and Tufano 2003, p. 6), therefore cash balance at the end of the year should be zero. Excess cash flow accrues as the remaining cash after the payment of interest, taxes, and dividends – the model assumes regular cash payments to investors. There is no incoming cash from equity. Cash expenditures on investments or incoming cash from divestitures are assumed to equal zero. The excess cash therefore can be responsible for a change of the working capital into negative or positive values.
3.4 Consistency between implicit and explicit assumptions
The Monte Carlo simulation has the explicit assumption of no major investments. This clashes with the implicit assumption of mixed maturity of debt, as to make a major investment Diageo may have to take out a large sum of new debt, throwing off the balance of mixed maturity time.
The simulation also explicitly assumes no new equity issues, but this could affect the implicit assumption of the EBIT calculation, as assets are used to calculate not only EBIT but ROA as well and could also strongly influence the cash flows that are part of the simulation.
The model also explicitly defines financial distress is defined with an interest coverage ratio <1. In case of any financial distress a permanent reduction in firm value of 20% is simulated.
The interest rates are all linked to the US interest rate and the fixed credit spread for different ratings. But in reality Diageo has offices in 110 countries, so they can borrow money wherever the rates are attractive. We would like to amend that these assumptions lead to very vague results.
4. Description of the working of the simulation
Monte Carlo methods are a class of stochastic simulation models that rely on repeated random sampling to compute their results. This form of simulation is used to understand the final distribution of outcomes and not only the expected values. It is therefore mostly suited for calculations when the underlying problem cannot be solved by a deterministic algorithm.
The present value of taxes paid and financial distress costs paid are simulated across a set of gearing policies. The forecasted EBIT as percentage of assets accounts for three uncertainties: The ROA for each geographical region, interest rate paid on the firm 's debt, and the currency exchange rates. The simulation for the EBIT uses an average return on assets (ROA), which is assumed to have normal distribution with mean of 18% and a standard deviation of 4%.
The model calculated for each gearing policy an interest rate and the total interest that the company would pay every year. The interest coverage ratio and the tax paid is determined by earnings and interest.
The Monte Carlo simulation issued new debt to finance a cash shortfall. The excess cash flow that the business generated was used to pay down outstanding debt (Chacko and Tufano 2003, p. 6). Whenever EBIT-Interest-Taxes-Total Dividends is negative, the simulation has new debt being raised (Chacko and Tufano 2003, p. 6). Regardless of the nature of a shortfall, it is a significant concern for a company, and is usually corrected promptly through short-term loans or equity injections. This assumption is out of touch with reality because a firm would probably rather cut dividends instead of raise debts. Furthermore, Diageo had a lot of retained earnings which could have been used to pay negative results or even dividends. Raising debts would be unusual way for Diageo to handle deficits.
5. The results of the simulation in comparison with Diageo 's stated capital structure policy
5.1 Diageo 's stated capital structure policy
Diageo was formed in November 1997 based on a merger between Guinness plc and Grand Metropolitan plc. Both firms had highly rated bonds (AA and A respectively) and were running with little debt. When the two firms merged, they decided to retain the financial policies of the merged firms and to attempt to keep the interest cover ratio (ICR) between five to eight. The ICR is measured as EBITDA divided by the interest payments. As a result of the stated capital structure policy, Diageo was rated A+.
Diageo was intent on keeping the interest coverage above 5, as if it fell below, there would be a chance of credit downgrading. The treasury team found that the firm’s interest coverage ratio was a critical value when rating agencies determine bond ratings. Analysts within Diageo had determined that if their rating was to fall to a BBB rating, it would only be able to raise only $5-8 billion in debt, and with a BB rating, less than $5 billion. Diageo’s competitors generally averaged a higher IRC (Chacko and Tufano, p. 11-12, Exhibit 4) to obtain an A+ rating. Due to the stability of Diageo brands, they could more easily raise debt than other A+ rated companies.
The strong credit rating benefitted Diageo in multiple ways. First of all, a higher credit rating leads to a lower debt interest rate. When firms with better ratings borrow, they are given better interest rates than those with lower ratings, even if the firms can borrow the same amount. In addition, Diageo was able to raise a relatively big amount of debt within a short period of time. This was supported by deep capital markets for highly rated firms such as Diageo. Diageo might have been able to raise additional debt of $8 billion in 12 months (while maintaining the A+ rating). A second benefit was the ability to access short-term commercial papers at attractive rates. Diageo was able to borrow a large part of its debt through commercial paper (47%) because of the high rating. With a BBB rating or lower, Diageo’s ability to raise commercial paper would have been highly limited.
Regarding the fixed assets, Diageo estimated spending about £400-500 million per year for the next five years to modernize existing production facilities and support organic growth (Chacko and Tufano 2003, p. 2).
5.2 The results of the Monte Carlo simulation
The company’s optimal capital structure is influenced by multiple channels. As a result of this, the optimal gearing cannot be found with a straightforward arithmetic problem. Assuming that the models output is reasonable, we see that the optimal gearing should imply an ICR of 4.2. This is lower than Diageo’s stated target range of five to eight, which is expected to be necessary to keep the high rating. A downgrade from A+ to BBB would yield in a higher interest rate and make it harder to raise financing.
5.3 Increase in gearing for Diageo
More debt could decrease the average capital cost, which would optimize the capital structure (Volkart 2008)). We can show this using the WACC as a measure of cost of capital1. As debt is less costly than the equity (, an increase of gearing will lower the WACC. On the other hand, raising more debt will result in a rating downgrade and also make the firm riskier. As a result, the stakeholders will require a higher return on equity (ROE). The increase of the cost of equity will effectively raise the WACC. As a result, the cost of equity will offset some benefits of increasing debt. When a specific point of debt is exceeded, the WACC goes up. Running with high debt and less equity, the firm risks becoming insolvent if the business takes a turn for the worse. As a result, the cost of debt increases which is reflected in the cost of bankruptcy and the cost of financial distress.
Apart from the trade-off between tax benefits of debt and costs of financial distress there are other variables to be taken into account when considering a change of the capital structure. There are more negative consequences which we want to point out. First, a rating downgrade may send a bad signal to the investors. This could lead to a negative effect on the stock price because the investors fear the bankruptcy. Diageo would not anymore be able to access the attractive short-term commercial paper (CP) borrowings as readily. Considering that roughly half of Diageo’s debt consists of such CP borrowings, this might be a source for concern. Furthermore the reputation might suffer and customers’ and suppliers’ perception might also change. Secondly, Diageo loses its financial flexibility, especially in times of stress. The possibilities to react fast in those times are bounded as the enhancement of debt is limited (Volkart 2008). For example, it would be difficult for Diageo to compete in a “price war”. Another important implication of a higher gearing and Diageo’s subsequent lower rating is that the firm’s ability to raise additional debt to fund acquisitions would be negatively affected.
Taking into account all those above arguments, we would not advise Diageo to increase its gearing.
6. Conclusion
We believe that the strategy switch from a more diversified and stable holding structure to a more focused and concentrated business could lead to higher earnings and a gain in the overall alcohol beverage market share. This new market position combined with the planned new acquisitions could lead to a future rating upgrade. However, these are only estimations and therefore the overall negative impact from the higher gearing offsets the chances of a value creation for the company. Keeping in mind possible further acquisitions, we have to state that an increase in debt and therefore a loss of financial flexibility is not the most helpful solution for Diageo, as they should focus on raising the stock performance to the market indices, and becoming the market leader in alcohol beverages through organic growth and acquisitions using the capital structure policy that they already have in place.
References
Brealey, Richard, and Myers, Stewart, and Allen, Franklin. 2014. Principles of Corporate Finance (McGraw-Hill Education, UK).
Chacko, George, and Tufano, Peter. 2003. “Diageo plc” Harvard Business School.
Volkart, Rudolf, and Alexander F. Wagner. 2008. Corporate Finance: Grundlagen von Finanzierung und Investition (Versus Verlag, Zürich).