Free Sample: Trade-Off Theory paper example for writing essay

Trade-Off Theory - Essay Example

The book gearing ratios and the market gearing ratios give us a clear picture on how Diageo managed their right hand side of the balanced sheet differently compared to competitors. In fiscal year end of 2000, before Diageo was going to spin off Burger King and Pillsbury, we should consider Diageo as an integrated business which includes packaged goods, alcohol, beer, and fast foods. Therefore, the industry’s ratios should be compared to Diageo. In addition, Diageo has $30 billion market capitalization. Therefore firms that are similar in size would be relevant.

The book gearing of Diageo is generally higher than the competitors in beer industry but lower than the package food industry average, and roughly at the same level as McDonalds and consumer goods industry average. Therefore, Diageo was considered in the middle of the entire industry average. We see that the market gearing of Diageo was 25%, which is slightly higher than both consumer goods industry average and packaged food industry average, therefore Diageo’s financial leverage was considered to be higher than industry average.

Admittedly, market gearing depends on the market conditions and the result of evaluation may be subjective (as market prices are changing all the time and the ratio may be inconsistent over time). Based on the book and market gearing ratios only, we see that Diageo fell within the industry average for book and market gearing, neither too conservative nor risk taking for managing the right hand side of the balanced sheet. Trade-Off Theory The trade-off theory of capital structure is based on the idea of recapitalization costs. Firm will seek to maintain an optimal structure by balancing the benefits and costs of debt.

The benefit mainly refers to interest tax shield, whereas the costs include expected financial distress costs such as bankruptcy cost and also costs associate with overinvestment and asset substitution problems. The implication of the trade-off theory is that firms have optimal capital structure and they adjust their leverage toward the optimum over time. In particular, a firm will try to maximize the value for its shareholders by equalizing the marginal cost of debt that results from the financial distress costs with the marginal benefit of debt that results from tax benefits.

In addition, trade-off theory also suggests that large, mature companies with stable cash flows and limited opportunities for investments should have higher leverage ratios since they have lower financial distress costs. Moreover, these firms will be able to take advantage of the tax deductibility of debt. On the other hand, smaller companies with significant growth opportunities should make limited use of debt to preserve their continuing ability to undertake positive-NPV projects. Application for Trade-Off Theory

We have constructed a model to estimate Diageo’s optimal capital structure. Diageo is planning to sell Pillsbury and spin off Burger King. So we have taken these two segments of the business out of the equation when accounting for sales. Sales are assumed to grow at 8% annually1. We calculate EBIT over sales from the period of 1998 to 2000. We then take the average of that ratio and use it to forecast the future operating cost and margin.

In addition, we have incorporated the fact that Diageo is integrating Guinness Brewing and there will be a 130 million cost reduction. Assuming Pillsbury will be purchased by General Mills during the year of 2001, Diageo will be able to obtain $5. 4 billion (3. 5 billion). However, according to exhibit 6 which shows Diageo’s liability structure, 3. 2 billion pounds of debt are going to be mature within a year. Therefore, we believe most of the proceeds from selling Pillsbury will be required to meet these short term obligations Diageo is facing. Diageo’s Cash account will be increased by 300 million pounds and we are assuming Diageo will have constant cash balance.

Diageo’s ability to raise short term debt through commercial papers will be extremely limited as their interest rate coverage is on the brink of falling below 5. Subsequently, Diageo’s short term debt will remain at an amount equal to 10% of long term debt after the repayment of short term obligations as some long term obligations will be classified as short term as it matures. We took the average of days in accounts receivable, inventories and account payable of past 3 years.

We have made our forecasts for these accounts presuming strategies for managing these accounts will not change. Even though in the Monte Carlo simulation depreciation is said to have a very minimal effect, however, we still adopted an amortization policy of 20 years straight line time horizon as we believe their machinery will not last forever. That is the reason why Diageo is spending 450 million pounds per year in capital expenditures to modernise it.

We are presented with Diageo’s current beta of 0.55, tax rate of 27%, debt to value ratio of 25% and debt to equity ratio of 33%. Using those information, we arrived at an unlevered beta of 0. 44 and we relevered it to get a result of 0. 52. We are using 5. 83% as risk free rate because our debt are mostly denominated in the US and thus the US government interest rate is chosen to be the risk free in our model. Market risk premium is set to 5%. By applying the relevered beta into CAPM, we get a levered cost of equity of 8. 4%. If we utilize the unlevered beta into CAPM, we will get unlevered cost of equity of 8%.

WACC is set as a forward looking function which incorporates the forward looking D/V and E/V ratio. The way we calculated for D/V is first by estimating interest expense by dividing EBIT by interest coverage ratio. Then we take interest expense and divided it by cost of debt, which is determined by rating of which is directly affected by interest coverage ratio. We added an extra constraint that if interest coverage ratio is below 2, cost of debt will be set at 8% as the rating may experience another decrease as interest coverage falls.