This corporate strategy is not riskless however Diageo must consider some

This corporate strategy is not riskless however

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This corporate strategy is not riskless however, Diageo must consider some capital structure changes. The company in its short history had a well balanced debt to equity structure of 52% to 42% respectively and had a credit rating of A+. This rating is significant because it affects Diageo’s ability to raise capital through debt. With this rating, the firm could raise $8 to 12 billion per year. The challenge was to determine which capital structure would best-fit the company’s new direction. The company’s core philosophy was that each division not only had to cover its operating expenses but also the cost of capital employed. Diageo was valued by the Treasury team in December 1998 for each of the 110 countries in which it operated. The team evaluated by using the static tradeoff theory of capital structure and the Monte Carlo analysis. The Monte Carlo analysis assumes zero year end balance. In the Monte Carlo analysis, Diageo assumed that financial distress was plausible if the interest coverage ratio was less than one. This meant the company’s EBT would not meet its interest payment obligations therefore it would have to borrow in order to cover its existing debt. On the flip side, with large cash flows, the company would issue special dividends to get itself back to the targeted interest coverage range. The static tradeoff theory was created by Franco Modigliani and Merton Miller (M&M) in 1958. This theory assumes that tax exists and there are costs for financial distress and bankruptcy. It suggests that because interest payments are tax deductible, debt is cheaper than equity and interest payments will shield some revenue from taxes. The theory states that the higher the company’s tax margin, the higher the tax shield. Diageo’s composite marginal tax rate was 27%. It was however difficult to gauge the cost of financial distress. In order to assess the event of financial distress, the company would have to model its cash flows over time over a broad range of market conditions. Cash flows would also have to be calculated for comparable companies in the alcoholic beverage industry. The results would Page 2
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provide information about the distribution of past profitability and a measure for future profitability. Using this information as well as debt financing information (maturity of
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