Introduction and Background
Diageo was formed in 1997 through the merger of two consumer product companies Grand Metropolitan plc and Guinness plc under the strategy of reducing costs through marketing synergies, cutting overhead expenses and increasing production and purchasing efficiencies. The new merger wanted to concentrate solely on the beverage alcohol business, so it sold its packaged foods (Pillsbury) and fast food (Burger King) businesses. While the mandate for Managing for Value came from the highest levels of Diageo, the treasury team was given the task of establishing the cost of capital for each of the different areas the company operated. The team had to create a simulation model which should consider new finance approaches, treasury functions to focus on, what the firm's risk footprints will be, how to calculate cost of capital and finally how to optimally structure capital.
How has Diageo managed its capital structure?
Both Grand Metropolitan and Guinness had little debt prior to the merger, which allowed them to benefit from relatively high ratings on their bonds (AA and A respectively).
Straight after the merger, Diageo's management announced it would maintain similar policies to the ones adopted by the two previous companies. This decision took the form of an implicit promise not to get into a debt level that would lead to a reduction in the credit rating of the company, which was aiming at an interest coverage between 5 and 8. A second target was set to keep EBITDA/Total Debt at 30%-35% level. This tranquilized investors and financial markets and as a consequence the company was given an A+ rating by credit agencies.
Table 1 presents some key financial indicators extracted from the case. As it can be observed, Diageo's debt level is low (market gearing level is around 25%), which together with the favorable...