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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 (McDonalds, Burger King, KFC Fried Chicken, Pizza Hut, Taco Bell (Mexican), CKE Restaurants Carls Jr., and Wendys) to casual family-style dining (TGI Fridays, Applebees, and Bob Evans Farms), and full-service restaurants (Shoneys).

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 billion. The market value of Diageos stockholders equity is much greater. With 788 million common

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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 Diageos 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 Diageos 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 Diageos restaurant business using the information in Exhibit 11-5.

Questions

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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 Diageos net debt ratio to calculate Diageos 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 Diageos restaurant business. 4. Explain why there is a difference between Diageos overall cost of capital and the cost of capital for its restaurant business.

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EXHIBIT 11-1
Diageo Income Statements (Dollars in millions)
Two Years Ago Amount $25,021 22,114 2,907 (573) 89 2,423 835 $1,588 $1.96 $0.62 % 100 88 12 (2) 10 4 6 One Year Ago Amount $28,472 25,271 3,201 (645) 108 2,664 880 (32) $1,752 $2.22a $0.70 % 100 89 11 (2) 9 3 6 Latest Year Amount $30,421 27,434 2,987 (682) 127 2,432 826 $1,606 $2.00 $0.78 % 100 90 10 (2) 8 3 5

Net sales Costs and expenses Operating profit Interest expense Other income (expense) Pretax income Income taxes Effect of accounting changes Net income Earnings per share Dividends per share

Before cumulative effect of accounting changes.

____________________________________________________________________________________________ Source: Diageo PLC, Annual Reports to Shareholders.

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EXHIBIT 11-2
Diageo Balance Sheets (Dollars in millions)
One Year Ago Assets Cash and cash equivalents Short-term marketable securities (at cost) Other current assets Total current assets Investments in unconsolidated affiliates Property, plant, and equipment (net) Intangible assets (net) Other assets Total assets Liabilities and Stockholders Equity Accounts payable Short-term borrowings Other current liabilities Total current liabilities Long-term debt Other liabilities Total liabilities Stockholders equity (790 million shares outstanding one year ago; 788 million shares in latest year) Total liabilities and stockholders equity 6,856 $24,792 28 100 7,313 $25,432 29 100 $1,452 678 3,140 5,270 8,841 3,825 17,936 6 2 13 21 36 15 72 $1,556 706
a

Latest Year % 1 5 14 20 5 40 32 3 100 Amount $382 1,116

a a

Amount $331 1,157 3,584 5,072 1,295 9,883 7,842 700 $24,792

% 2 4 16 22 6 39 30 3 100

4,048 5,546 1,635 9,870 7,584 797 $25,432

6 3 12 21 33 17 71

2,968 5,230 8,509

b

4,380 18,119

Approximates market value. Market value equals $8,747 million. ____________________________________________________________________________________________ Source: Diageo PLC, Annual Reports to Shareholders.
a b

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EXHIBIT 11-3
Selected Market Data for Diageo

Diageos beta Riskless returns: Short-term Intermediate-term Long-term

1.00 Market risk premium: 5.13% 5.50 6.00 Short-term Intermediate-term Long-term 8.40% 7.40 7.00

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EXHIBIT 11-4
Fair Market Yield Curves

3 MO 6 MO 1 YR 2 YR 3 YR 4 YR 5 YR 7 YR 10 YR 20 YR 30 YR

A1 6.00% 5.89 5.58 5.60 5.69 5.80 5.84 6.06 6.08 6.68 6.71

A2 6.03% 5.92 5.59 5.60 5.69 5.89 5.89 6.09 6.23 6.75 6.75

A3 6.05% 5.94 5.73 5.61 5.79 5.95 6.09 6.17 6.37 6.87 6.81

Source: Bloomberg, L.P.

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EXHIBIT 11-5
Selected Data for Comparable Restaurant Companies

PREFERRED STOCK FIRM Applebees International Bob Evans Farms Brinker International CKE Restaurants McDonalds NPC International Shoneys Wendys International LISTED NASDAQ NASDAQ NYSE NYSE NYSE NASDAQ NYSE NYSE BETA 1.30 0.95 1.70 1.15 1.00 0.80 0.90 1.15 TOTAL DEBT ($ MILLIONS) $ 28.5 54.7 104.7 86.7 4,820.1 81.4 440.4 147.0 STOCK ($ MILLIONS) $ 411.1 -

COMMON SHARES (MILLIONS) 31.0 42.3 72.1 18.4 694.0 24.5 41.5 103.4

CLOSING STOCK PRICE ($) $ 22.750 19.000 15.125 16.000 45.125 7.250 10.250 21.250

Sources: Bloomberg, L.P., and Value Line Investment Survey .