DIAGEO PLC Case Solution & Answer

DIAGEO PLC Case Solution

• Motivation for Spin off of Pillsbury & Burger King

            There were some important motivations for Spinning off Pillsbury and Burger King. First of all, by selling Pillsbury the company would gain $ 5.1 billion cash and $ 5.4 billion worth shares of General Mills. Along with this, cash would also be received from the sales of Burger King. The main focus of Diageo was on the beverage alcohol business and it wanted to utilize cash for growing and expanding this business. The growth could be either through acquisitions or through organic means. The case also highlights that Diageo has been working on a joint bid for the acquisition of its rival alcohol business, Seagrams.

Question 2

Monte Carlo Simulation

The Monte Carlo Simulation model has been generated on the basis of the guidelines provided and using the inputs provided in this question. Normal distribution has been used to simulate the three variables which are the exchange rate, the interest rate and the ROA. The mean values and the standard deviations have been taken to be same as provided. Based on these simulated variables, the EBIT has been computed as well as interest coverage has been calculated.

 If interest coverage is greater than 1, then the book value of asset in next year will increase by 20% and vice versa. The financial distress costs are taken to be 20% of asset value. The marginal tax rate is 27% and by using the respective interest rates, the present value of tax shields and financial distress costs as well as the net NPV has been computed for 10 years. The same simulation has been performed for debt to capital ratios from 10% to 90%. The average NPV for each capital structure has been then computed and the decision has been made. The graph for the NPV for the most optimal capital structure and the graph for the random values of the simulated variables for 10 years are shown below:

     The simulation model is shown in the chart below:

Question 3

3.1 Recommended Optional capital Structure

            The average net benefits (NPV) for the range of the capital structures are as follows:

Capital Structure	Average NPV (Net Benefit)
10%	58.972
20%	91.104
30%	165.671
40%	209.584
50%	142.670
60%	310.148
70%	306.365
80%	390.653
90%	386.301

            The recommended optimal capital structure is 80% debt and 20% equity.

3.2 Range of capital structure

            The range of the optimal capital structure is from 80% to 90%. This could be checked in the excel spreadsheet by pressing F9.

3.3 Range of Debt Rating

            The range of the debt rating is A+ to B, which could also be checked from the excel spreadsheet by looking at the interest coverage ratios. This should be maintained by the firm so that it could have all the benefits of borrowing capital as in past. If this credit rating reduces, then the firm will face financial distress costs and would also face borrowing difficulties.