Diageo Q2

Q2:

The static trade off theory was formed in the middle of 1970s and it was based on the Modigliani-Miller theory, whose core was that under certain assumptions, the value of a company is the same no matter whatever the capital structure of the company uses. However, the assumptions MM theory uses were not realistic, when companies are considering enjoying the tax deduction by borrowing, they should also take the cost of financial distress brought by raising debt into consideration. In order to maximize the value of a company, the company should find the optimal point where the marginal value of the benefit associated with debt issues exactly offsets the increase in the present value of the costs associated with issuing more debt, and this is the static trade off theory in how to find the optimal target financial debt ratio by focusing on the benefits and costs of issuing debt.

Before applying the static trade off theory to Diageo, we need to discuss the 3 factors of the simplest static tradeoff theory. Firstly, the most obvious benefit of issuing debt is the tax deductibility of interest payments, which leads to more profit flowing into investors instead of the government, but it is complicated to argue if taking personal taxes into consideration. Secondly, issuing debt reduces the conflict between managers and shareholders by limiting the available free cash flow to managers and thus managers tend to be more conservative instead of wasting shareholder’s money. On the other hand, issuing more debt also brings the company with the cost of financial distress when the company is unable to make interest payment. Also, issuing excessive debt also decrease a company’s credit rating, makes it more difficult raising money from the market and faces a higher interest rate.

Suppose Diageo has achieved the optimal financial structure, where the sum of present value of taxes paid and cost of financial distress is the smallest. If Diageo choose to issue more debt, it will have less tax to pay due to the tax shield, but it has to suffer more cost of financial distress since more debts means bigger possibility that the company is not able to make the interest payment, and a lower credit rating that results in a higher interest rate, which makes the company more difficult in raising money. Additionally, if Diageo faces seriously financial distress, competitors could take the opportunity to advantage of the situation by increasing their shares in the market, consumers may change their preference to products of company that are not in financial distress and the management might focus on the financial crisis with no spare attention on running the business, these factors together influences the cost of financial distress, which makes the profits flowing to the equity owners shrink, and if it really can’t pay its interest payment, it will be a disaster for investors.