C-11-1
Minicase 11
Divisional Cost of Capital
Diageo PLC (Diageo) operates three major lines of business: restaurants, alcoholic beverages,
and food items. Its major restaurant chain is Burger King. Major food items include Haagen
Dazs ice cream. Alcoholic beverages include the Segrams brands. Restaurants account for about
25% of sales and 10% of profits, alcoholic beverages contribute 50% of sales and 60% of profits,
and food items account for 25% of sales and 30% of profits.
The Restaurant Industry
The U.S. restaurant industry is highly competitive with a large number of national chains
competing with local restaurants. The national chains offer a menu of choices ranging from fast
food (McDonald’s, Burger King, KFC Fried Chicken, Pizza Hut, Taco Bell (Mexican), CKE
Restaurants’ Carl’s Jr., and Wendy’s) to casual family-style dining (TGI Friday’s, Applebee’s,
and Bob Evans Farms), and full-service restaurants (Shoney’s).
The long-term outlook for the restaurant industry is favorable. The industry will continue to
benefit from two-wage-earner families, who have larger disposable incomes but less time to
prepare meals at home. Consequently, industry analysts expect that the trend toward eating away
from home or bringing prepared meals home will continue into the foreseeable future, primarily
benefiting the more efficient restaurant operators.
Overview of Diageo
Exhibit 11-1 furnishes income statements for Diageo and Exhibit 11-2 furnishes balance sheets.
Diageo has book liabilities of $18.1 billion, and book value of stockholders’ equity of $7.3
C-11-2
billion. The market value of Diageo’s stockholders’ equity is much greater. With 788 million
common shares outstanding and a share price of $55.875, the market value of its stockholders’
equity is $44.0 billion, or roughly six times its book value.
Financial Leverage
Diageo measures financial leverage on both a market value and an historical cost basis. Diageo
believes it appropriate to measure debt net of its available cash. This approach takes into account
its large investment portfolios held outside the U.S. These portfolios are managed as part of
Diageo’s overall financing strategy and are not required to support day-to-day operations. Net
debt reflects the pro forma remittance of the value of these portfolios (net of related taxes) as a
reduction of total debt. Total debt includes the present value of operating lease commitments.
Diageo believes that market leverage (defined as net debt expressed as a percent of net debt plus
the market value of equity, based on the year-end stock price) is the most appropriate measure of
its financial leverage. Unlike historical cost measures, the market value of equity primarily
reflects the estimated net present value of expected future cash flows that will both support debt
and provide returns to shareholders. Diageo has established a long-term target range of 20%25% for its market net debt ratio, which it believes will optimize its cost of capital.
Cost of Capital
Diageo has reported its overall cost of capital to be approximately 10%. It has not reported costs
of capital separately for its three lines of business. Estimate Diageo’s WACC using the
information furnished in this case and the market data in Exhibits 11-3 and 11-4. Assume a 34%
income tax rate and a target long-term debt rating of A-2. Then estimate a WACC for Diageo’s
restaurant business using the information in Exhibit 11-5.
C-11-3
Questions
1. Diageo subtracts the value of its portfolio of short-term investments, which is held outside
the United States and is not required to support day-to-day operations, from its total debt
when calculating its “net debt ratio”. Use Diageo’s net debt ratio to calculate Diageo’s
overall WACC.
2. Should Diageo use its overall cost of capital to evaluate its restaurant investments? Under
what circumstances would it be correct to do so?
3. Estimate the cost of capital for Diageo’s restaurant business.
4. Explain why there is a difference between Diageo’s overall cost of capital and the cost of
capital for its restaurant business.
C-11-4
EXHIBIT 11-1
Diageo Income Statements
(Dollars in millions)
Two Years Ago
One Year Ago
Latest Year
Amount
%
Amount
%
Amount
%
$25,021
100
$28,472
100
$30,421
100
22,114
88
25,271
89
27,434
90
Operating profit
2,907
12
3,201
11
2,987
10
Interest expense
(573)
(2)
(645)
(2)
(682)
(2)
89
-
108
-
127
-
2,423
10
2,664
9
2,432
8
835
4
880
3
826
3
-
-
(32)
-
-
-
$1,588
6
$1,752
6
$1,606
5
Net sales
Costs and expenses
Other income (expense)
Pretax income
Income taxes
Effect of accounting changes
Net income
Earnings per share
$1.96
$2.22a
$2.00
Dividends per share
$0.62
$0.70
$0.78
a
Before cumulative effect of accounting changes.
____________________________________________________________________________________________
Source: Diageo PLC, Annual Reports to Shareholders.
C-11-5
EXHIBIT 11-2
Diageo Balance Sheets
(Dollars in millions)
One Year Ago
Assets
Cash and cash equivalents
Latest Year
Amount
%
Amount
%
$331
1
$382a
2
a
4
Short-term marketable securities (at cost)
1,157
5
Other current assets
3,584
14
4,048
16
5,072
20
5,546
22
Investments in unconsolidated affiliates
1,295
5
1,635
6
Property, plant, and equipment (net)
9,883
40
9,870
39
Intangible assets (net)
7,842
32
7,584
30
700
3
797
3
$24,792
100
$25,432
100
$1,452
6
$1,556
6
Short-term borrowings
678
2
706a
3
Other current liabilities
3,140
13
2,968
12
5,270
21
5,230
21
b
33
Total current assets
Other assets
Total assets
1,116
Liabilities and Stockholders’ Equity
Accounts payable
Total current liabilities
Long-term debt
8,841
36
Other liabilities
3,825
15
4,380
17
17,936
72
18,119
71
one year ago; 788 million shares in latest year)
6,856
28
7,313
29
Total liabilities and stockholders’ equity
$24,792
100
$25,432
100
Total liabilities
8,509
Stockholders’ equity (790 million shares outstanding
a
Approximates market value.
Market value equals $8,747 million.
____________________________________________________________________________________________
Source: Diageo PLC, Annual Reports to Shareholders.
b
C-11-6
EXHIBIT 11-3
Selected Market Data for Diageo
Diageo’s beta
1.00
Riskless returns:
Market risk premium:
Short-term
5.13%
Short-term
8.40%
Intermediate-term
5.50
Intermediate-term
7.40
Long-term
6.00
Long-term
7.00
C-11-7
EXHIBIT 11-4
Fair Market Yield Curves
A1
A2
A3
3 MO
6.00%
6.03%
6.05%
6 MO
5.89
5.92
5.94
1 YR
5.58
5.59
5.73
2 YR
5.60
5.60
5.61
3 YR
5.69
5.69
5.79
4 YR
5.80
5.89
5.95
5 YR
5.84
5.89
6.09
7 YR
6.06
6.09
6.17
10 YR
6.08
6.23
6.37
20 YR
6.68
6.75
6.87
30 YR
6.71
6.75
6.81
Source: Bloomberg, L.P.
C-11-8
EXHIBIT 11-5
Selected Data for Comparable Restaurant Companies
STOCK
FIRM
LISTED
BETA
PREFERRED
COMMON
CLOSING
TOTAL DEBT
STOCK
SHARES
STOCK
($ MILLIONS)
($ MILLIONS)
(MILLIONS)
PRICE ($)
Applebee’s International
NASDAQ
1.30
$ 28.5
-
31.0
$ 22.750
Bob Evans Farms
NASDAQ
0.95
54.7
-
42.3
19.000
Brinker International
NYSE
1.70
104.7
-
72.1
15.125
CKE Restaurants
NYSE
1.15
86.7
-
18.4
16.000
McDonald’s
NYSE
1.00
4,820.1
$ 411.1
694.0
45.125
81.4
-
24.5
7.250
440.4
-
41.5
10.250
147.0
-
103.4
21.250
NPC International
Shoney’s
Wendy’s International
NASDAQ
NYSE
NYSE
0.80
0.90
1.15
Sources: Bloomberg, L.P., and Value Line Investment Survey.