Monte Carlo Recommendation Essay Example

Monte Carlo Recommendation Essay The Monte Carlo structure basically exhibits the total present value of tax paid and distress cost. The optimal interest coverage ratio, which is EBIT to interest expense, should be set to 4. 2 because this is where the firm can attain the minimum cost. In another word, the reason that is the most advantageous position is because the sum of tax paid and distress cost is the smallest among all other points. The downside is that Diageo will not be rated BBB instead of A due to the fall in interest coverage ratio from 5 to 4.2. The total debt is projected to be   9491 million. According to treasury groups recommend, the total capitalization will increase from 12,167 to   14,777 million4, which represents a 21% increase going forward. Debt to equity ratio will proliferate from 1. 3 to 1. 8. Book gearing will escalate to 64% and market gearing to 34%. Allied Domecq has book and market gearing of 88% and 29% respectively. They are still able to maintain a rating of A-. Since the rating for Diageo is going to decrease regardless, a higher market gearing understandable as they are now able to pay less tax and not withstanding a huge distress cost. Though the Monte Carlo model captured several important features of the dynamic capital structure, a number of features are still missing. In order to fully capture the dynamic nature of the capital structure, an ideal model has to be able to adjust to the optimal capital structure over time, which means the D/E ratio and interest coverage ratio should be reverting around the optimal level. We will write a custom essay sample on Monte Carlo Recommendation specifically for you for only $16.38 $13.9/page Order now We will write a custom essay sample on Monte Carlo Recommendation specifically for you FOR ONLY $16.38 $13.9/page Hire Writer We will write a custom essay sample on Monte Carlo Recommendation specifically for you FOR ONLY $16.38 $13.9/page Hire Writer The model developed by Diageos treasury group only incorporated half of this ideal feature: when the interest coverage ratio was too high, the company issued a special dividend to gear itself back to the targeted coverage range; however, there was no provision in the model for issuing equity to pay down debt when coverage fell, consequently no effort was taken to revert the coverage back to the target level. In addition, too many specifics of the financial distress costs were missing as the model only provided a simplification of the real world situation. For instance, court costs and agency costs were both hard to estimate and therefore were missing from the model. Moreover, instead of assuming a likelihood of bankruptcy, the model attempted to estimate the costs of financial distress as a one-time permanent 20% reduction in firm value when the EBIT was less than the interest. The motivation was from the research paper Designing Capital Structure to Create Shareholder Value by T. Opler, M. Saron, and S. Titman, as they showed highly levered firms lost an additional 7% of market value during industry downturns relative to the average firm. However, there was no justification for using a 20% reduction. In addition, the model did not consider the affect that company will be going through major changes in the next 2-3 years, such as acquisition of potential beverage companies and selling off Burger King. These deals would probably result a substantial change on Diageos capital structure. Lastly, Monte Carlo model was not able to capture the dynamics of the market condition over time. For the model to be more efficient, it has to be adjusted constantly to reflect the current situation of the market condition. Pillsbury and Burger King Strategically, if a company is running a set of businesses, in order to achieve the optimal profit margin it would either choose to go full-scale or to be a niche. In Diageos case, food business is as a middle segment of the pack, therefore demerger Pillsbury and Burger King would allow Diageo to focus on beverage alcohol business. Concentrated business would make it more feasible for growth through innovation around unrivalled portfolio of brands and providing an improved base for later sustained profitable top line growth. Pillsbury, which contributed a quarter of Diageos operating profits, was too small to prosper on its own and at the same time its core business Old EI Paso Mexican was under a fierce competition in American market. Therefore by selling Pillsbury to its rival General Mills, the Pillsbury could have greater potential for cost synergies. Since Diageo still owns 33% of the new General Mills/Pillsbury business, the cost synergies would also benefit Diageo as a shareholder. Burger King, which resembles the smallest part of operating profit, is also the fastest-growing segment of Diageo which might enjoy a higher rating than Diageo itself since it is in the fast food industry. Therefore from a long term perspective, the demerger of Pillsbury and Burger King would provide more capital for further expansion. There was a remarkable performance of the core business in Diageo: the alcoholic beverages-Spirits and Wine segment and Guinness Brewing segment both revealed to experience increase in the market share. The profits attained from those two segments accounted for half of Diageos operating profits during 2000. In addition, concentrating solely on its core business would allow Diageo to enjoy marketing synergies, production and purchasing efficiencies. These benefits could arise from cost saving in manufacturing, procurement and supply; the savings could also pass through distribution system and have enhanced ability to reach consumers. As the case indicates, Diageo was in the process of integrating its two core businesses, which might result in cost reductions of i 130 million annually. Moreover, by concentrating on beverage alcohol business, Diageo is able to capture more cost synergies when acquiring rival firms. Lastly, concentration also reduced the chance for the sub-companies under Diageos alcohol beverage category to become the potential acquisition targets of its rival companies.