Diageo Case Study

3) The interest resulting from the debt also will cost to the company even it is taxable. The interest is fixed base on the level of the debt even the company does not generate profit. This would need to be careful when take on the debt comparing to use its own capital. And the creditor may come to intervene on the business when the company has difficulty to service its debt.

On the basis of risk and return, how does the increased leverage affect a company and the individual shareholder?

The company lost money almost every year since its leveraged buyout by Coniston Partners in 1989. The income generated was not sufficient to service the interest expenses of the company which stood at $2.62B in 1996. From Exhibit 1, we can say that interest coverage ratio computed as EBIT / Interest Expense was 1.31 in 1989 and has been decreasing over years and currently stands at 0.59. This raises a question of how the company can meet its interest payments without raising cash or selling assets.

In general, the lower the company's reliance on debt for asset formation, the less risky the company is since excessive debt can lead to a very heavy interest and principal repayment burden. This is demonstrated through statistics such as high financial risk, low interest coverage ratios, and high debt ratios. However, when a company chooses to forgo debt and rely largely on equity, as in the case of AHP, the company does so at the expense of a tax reduction effect supplied by interest payments. Thus, a company has to consider both risk and tax issues when deciding on an optimal debt ratio.

Based on the Time Interest Earned Ratio Landry’s ability to pay interest bills from profit earned decreased. In 2002 Landry’s could pay their interest bill just over 13 times from earnings before interest tax. In 2003 Landry’s ability to pay interest bills was almost cut in-half to 7 times. We think that as a result of the decrease in ability to pay interest bills, creditors could be concerned about these findings.

Diageo’s mixture of the short- and the long-term debt and the currencies can be a subject for concern: having 47% of the debt was raised via short-term commercial papers and thus exposing the company to the refinancing risk in case of the adverse changes in the interest rates. Currencies’ mixture of debt was also quite concerning: with the ca. 50% of operating profits

The advantage of debt financing is that interests paid on such debt are tax deductible. If a company has the intention of maintaining a permanent debt, the present value of the tax shield can be obtained by discounting them by the expected rate of return demanded by the investors who hold the debt (this is a perpetuity, where in reality would be the maximum possible present value for the tax shield). This tax shield value reduces the tax bill and increases the cash payment to investors, increasing the value of their investments.

In addition, as we are comparing the profit margin and operating profit margin, we notice that interest expense, from 2006 to 2010, consumed a relative small portion of sales proceeds comparing to 2011. In 2011, the profit margin for HH is -1.46% and the operating profit margin for HH is -0.74%. Since profit margin includes interest expense in the calculation while operating profit margin does not, we can conclude that HH has about the same amount in interest expense as the amount of operating loss before interest. This finally doubles the amount of company’s loss at the end of the cycle. This big amount of interest expense leads us to study HH’s leverage ratios.

Having a conservative debt policy increased the credit worthiness of the firm. Because the firm believes that the interest coverage ratio is a critical factor for credit rating agencies, they attempted to keep this ratio very high. Also, by having a higher credit rating they are able to access short term commercial paper borrowings at better rates. This type of short term borrowing makes up 47% of Diageo’s portfolio. By not having a strong credit rating they would not be able to lock in the low rates which would impact their business significantly.

FIN 450 Rami Ahmed Al Hasan @16253 Elias Elkoussa @17067 May Mohammed @14325 Deena Shalab@16457 Reem Hani Arab @16185 CASE 4 An Introduction to Debt Policy and Value 1 (Table format and content from case) 0% debt/100% equity 25%debt/75% equity 50%debt/50% equity BV of debt 0 $2,500 $5,000 BV of equity $10,000 $7,500 $5,000 MV of debt 0

Although the increased leverage decreases the amount of earnings available to stock holders from 496.9 million to 451.7 million for a total of 45.2 million dollars, it has a positive affect for the company’s tax structure. It actually reduces the company’s tax liability by 83 million dollars! Without the debt they have to pay 952.5 million dollars in taxes. However after an increase of 30% leverage, the new tax liability is 869.5 million dollars.

Leveraging the company would affect taxes because interest is tax deductible. Therefore, the more debt American Home Produces takes on, the less the company will have to pay in taxes. Also, when leveraging up there is tax savings the company will receive due to the interest tax shield.

Swiss regulators have established themselves as being very careful regarding the demands of the country’s largest banks along with their general capital ratio norms, which are known to be highly stringent globally. This opens room for imposing stricter leverage ratio requirements over banks. To evaluate the impact of a rule making its obligatory for banks to uphold a leverage ratio ranging between 6-10%, in the third quarter of 2013 UBS reported a leverage ratio of 4.2% where as Credit Suisse reported a figure of 4.1% (at the banking industry level).

According to Smith and Stulz (1985), firms that face higher expected costs of financial distress have larger incentives to use derivatives because derivatives can reduce the present value of bankruptcy and the probability of financial distress. Firms can use derivatives to reduce the variance of a firm 's cash flow or earnings which enable firm to have sufficient cash flow to fulfill its fixed payment obligations and reduce the probability of financial distress (Aretz and Bartram, 2010; Supanvanij and Strauss, 2010). Similarly to previous studies, I have used leverage as a proxy for financial distress (e.g., Tufano, 1996; Rogers, 2002; Aretz and Bartram, 2010). Leverage is measured with the ratio of total debt to book value of assets (e.g., Coles et al; 2006).

Diageo plc is a British multinational alcoholic beverage company that produces and distributes alcoholic and non-alcoholic beverages. The company headquarter located in London, UK with a revenue base of 15.64 Billion (GBP) and 30,400 workforce worldwide. As a custodian of the most world iconic drinks, its brands include: Malta Guinness, Black Label, Smirnoff, Johnnie walker, Captain Morgan, Windsor, JB, Cîroc and Baileys just to mention but a few. The world’s largest distiller of malting, brewing until it was overhauled by China’s Kweichow Moutai in 2017. The name of its chief Executive officer is Ivan Menezes and its president (Deirde Mahlan).