Context:
Diageo’s principal activity is manufacturing and distributing spirits and wine business with high recognized brands in the world like Malibu, J&B or Johnnie Walker. Diageo was formed in November 1997, following the merger of Guinness plc and Grand Metropolitan. Diageo consists of four main businesses: spirits and wine business, beer business with Guinness Brewing, Pillsbury with global food giant boasting four mega brands, and Burger King with fast food business. The principal matter to Diageo is focusing in a relevant portfolio of brands in alcohol business.
To concretize this goal in 2000, Diageo proclaimed the sale of one of your small business: the Pillsbury to General Mills, Diageo also announced its intention to sell 20 percent of its stake in Burger King.
4. If you apply the text book tradeoff theory to Diageo, what can be implied about the optimal capital structure of Diageo prior to the sale of Pillsbury and spinoff of Burger King?
The tradeoff theory is explained by a tradeoff between the interest tax shield and the cost of bankruptcy. The company chooses how much debt and equity finance to use by balancing the cost and benefits of these two types of financial way. If we apply this model to Diageo, in a historic structure based in lowers debt’s ratios we can see the optimal debt ratio can be higher that historical debt ratio. The Diageo should borrow up to the point where:
Marginal benefits of the tax shield =Marginal cost of financial distress
When this happen the debt increases the firm value by reducing the corporate tax bill as we can see in the next chart:
In Diageo case, the major issue is the measure of bankruptcy costs and the uncertainty of operating income. To resolve so ...