Interest Rate – based on Exhibit 8, item (b), all interest rates are linked to the US interest rate so we used the base US rate from Exhibit 5 and then did a random variable generator to calculate an interest rate between 2% and 14% based on the Part II instructions. The determined interest rate was used to calculate the asset level each year. Assets began at the 2000 level of £16.1 billion and increased each year by the calculated interest rate based on the case instructions. The interest rate was also used to estimate interest payments for the outstanding debt.
To calculate Earnings Before Interest and Taxes (EBIT), we estimated Return on Assets (ROA) and the impact of changes in foreign currency rates. ROA was estimated with a random number generation based on normally distributed amounts with a mean of 18% and a standard deviation of 4% (see item (e) of Exhibit 8). The impact of fluctuations in foreign currency was estimated based on the current rate of 1.514 $/Pound and a standard deviation of 0.17 (see instruction for
Part II, first bullet, item 3). We used a random number generator to determine the fluctuations from year to year and then calculated the percentage change year over year. The percentage fluctuation was applied to the calculated ROA to determine what the EBIT would be including potential foreign currency fluctuations.
Taxes were estimated to be 27% based on the facts in the case.
Once we calculated the net profits, we then estimated regular dividends paid each year. Based upon the cash flow statements in Exhibit 1, Diageo was paying approximately 35% of the operating income out as regular dividends each year. We used the same estimated rate of dividend payments for each period.
Interest Coverage was calculated each year based the calculated EBIT and interest payments.
When the interest rate coverage exceeded 8 (Diageo aimed to keep their coverage ratio between
5 and 8), we estimated that Diageo paid out a special dividend to decrease their coverage to a ratio of 5. We altered this assumption so the ratio was between 8 and 11 and then between 2 and
5 in order to see the variation of the capital structure on the NPV of the taxes paid and financial distress costs.
In all scenarios, we assumed that if the interest coverage ratio fell below one, that the company was in financial distress and had a permanent decrease in assets of 20%.
Once we determined whether there was a special dividend, we were able to calculate the remaining cash balance. Diageo had a year-end zero cash balance policy so any remaining cash after all dividends were paid would go to pay off the outstanding debt. If there was not enough cash to cover expenses and the regular dividend, Diageo would borrow the necessary balance to increase the outstanding debt balance.
2) Based on our simulations, we would recommend that Diageo change their future capital structure to include additional debt. With their current structure (an interest coverage ratio between 5 and 8) the average NPV of taxes paid is £12,038.8 million with a standard deviation of
£1,204.0 million while the average NPV for financial distress costs is £1.6 million with a standard deviation of £71.5 million.
Increasing that range to 8 to 11, increases their average NPV of taxes paid to £12,411.9 million with a standard deviation of £1,235.0 million while the average NPV for financial distress costs is £0 with £0 standard deviation while decreasing that range to 2 to 5 decreases their average
NPV of taxes paid to £11,152.2 million with a standard deviation of £1,159.5 million with an average NPV for financial distress costs of £1.3 million with a standard deviation of £63.9 million. By increasing the debt in their capital structure, Diageo could reduce their taxes paid while only minimally increasing the possibility of financial distress costs. Decreasing their debt could help

eliminate their possibility of financial distress costs but would significantly increase the amount in taxes they would pay. Diageo’s current capital structure does provide some benefit by reducing taxes with the interest payments but requires them to pay additional cash out for those tax payments that could otherwise be used for potential acquisitions or company operations.
Their current structure is a good conservative position but they could increase their debt and reduce their tax exposure with minimal impact for potential financial distress.